As any builder will tell you, it is impossible to know with certainty the exact amount a project is going to cost. Variables affecting the cost run the gamut from labor and material costs to delays for unforeseen conditions, weather or other causes. The longer a project is expected to take, the more uncertain the project’s costs become. For this reason, contingencies are included in budgets by all parties involved: owners, contractors, subcontractors and, occasionally, lenders. Ideally, these contingencies will allow the project to absorb delays and other unexpected events without the owner being forced to contribute additional equity (and “balance the loan”) at the time. The owner will desire maximum flexibility over the re-allocation of the contingency(ies) to line items that will then be funded by the lender—while the lender will want to “control” the use of contingency line items to the extent possible.
With this in mind, let’s look at some of the competing motivations at play and “typical” loan agreement provisions regarding the use (or re-allocation) of contingency(ies) to other line items in the Project Budget.
The Where, the When and the From What
The amount and type of contingencies will inevitably vary depending on the type of the project and where (and when) the project is being constructed. There are different variables associated with a ground-up construction project as opposed to refurbishing an existing building. In the former, there are potential “unforeseeable circumstances” associated with, for example, subterranean features whereas with the latter there are unknowns with the structure itself. Similarly, the location of the project will have an effect on the type and number of contingencies. A warm, sunny locale is less likely to need to build in room for potential delays during winter months, while that same project may need to protect against a much more catastrophic event such as a hurricane or flood damage.
Once the nature of the contingencies is determined, a lender will want to have control over the amount and allocation of contingency funds set out in the construction budget. For example, the loan agreement might provide, with regards to re-allocations from contingency line item(s) to other line items, that:
“Borrower may, with Agent’s prior consent, reallocate to any Line Item the amount of any portion of the Loan proceeds attributable to the Contingency Line Item which has not been reallocated to any other Line Item and which Agent, in its judgment based upon the then current state of completion of the Required Improvements, any existing cost overruns and any potential cost overruns as may then be foreseen or anticipated by Agent, shall deem to be available for reallocation.”
Or it might provide that:
“Subject to the prior approval of Agent, which shall not be unreasonably withheld, the Borrower may revise the Loan Budget from time to time to move amounts available under the Budget Line denominated “Contingency” to other Budget Lines.”
The “loan balancing” provisions of the loan agreement will also often “take into account,” among other factors, possible re-allocations from the contingency line items to other line items in the Budget.
Specificity vs. Flexibility
Regardless of the “approval standard,” typically, the lender will require approval. The level of detail will vary from project to project. A lender may also want to have more specificity in the budget by, for example, treating hard cost and soft cost contingencies differently. A lender may be more willing to allow for a larger hard cost contingency and more flexibility in its use since the money spent is more likely to result in increased value of the improvements at a given stage of construction. A lender should always make sure that the requested use of contingency funds are actually required to address an unforeseen event and will add real value to the project. If this is not the case, lender should insist that the borrower use other funds (e.g., equity) to cover the expense.
On the other hand, Borrowers will request flexibility and less lender control over how (and when) the contingency line item is allocated to a line item that will be funded. A borrower will argue that he is generally much closer to the day-to-day construction of the project and has a much better sense of what funds are needed and when. A borrower may suggest bifurcating the contingencies into hard and soft cost items because they may be able to negotiate for at least more control over the hard cost contingency than they would have over a combined fund. For example, if the cost of concrete goes up, it goes up. There is little the borrower can do about it, so the borrower may be able to negotiate more discretion for these types of allocations. Ultimately, the borrower will likely need to give up complete control over allocation of contingency funds, but it should still try and negotiate for as little lender discretion as possible.
Don’t Forget the Big Apple
An important thing to remember (if in New York) when negotiating these categories and distinctions is New York’s lien law. In a nutshell, New York’s lien law allows lenders to file their building loan agreements, or a notice of lien, and an affidavit signed by borrower and limit exposure to later-in-time mechanic’s liens on the project. However, the law only allows for protection of “hard costs” and “indirect costs” (such as materials; payments to contractors, architects, engineers; loan and title insurance costs; and mortgage and real estate taxes), but not for “soft costs” (such as borrower’s legal fees, marketing expenses, supervisory construction fees and overhead costs). Borrowers and Lenders operating in New York will need to factor the potential protections they may receive into consideration of budgeting for contingencies—perhaps with a preference towards creating separate line items for hard and soft cost contingencies.
At the end of the day, both borrowers and lenders will want “the same thing” generally—they both want the project to be completed on time and on budget. This requires a contingency that is sufficient to cover unforeseen circumstances (including a cushion). If the project “uses up” the entire contingency early on in the construction life cycle, the borrower will have to balance the loan and contribute equity (possibly putting the project in jeopardy)—this is not in anyone’s interest. Where the interests of the borrower and lender diverge, however, is in the extent and scope of lender’s control over the re-allocation of the contingency(ies) to other line items. This “tension” is not insurmountable, however, and the strategies discussed above can help effect a practical and workable outcome.