May 18-May 31, 2016 —
COLORADO REAL ESTATE JOURNAL
— Page 21
Law/Finance
C
os t
cont a i nment
and cost certainty
are two of the most
important issues for construc-
tion project owners. Owners
need to know as accurately as
possible how much a project
will cost before the project starts
and they need to control costs
during the project. On most
projects, owners achieve those
goals in the preconstruction
phase by obtaining competi-
tive, fixed-price bids or requir-
ing a guaranteed maximum
price. When projects need to
be fast-tracked or they involve
enough potential uncertainty
that contractors have difficulty
arriving at a fixed bid or guar-
anteed maximum price, the
best option is often a cost-plus
contract with an agreed upon
fee and no GMP.
Under a cost-plus contract,
the owner agrees to pay all rea-
sonable and necessary costs the
contractor incurs to build the
project – subcontractor costs,
materials, reasonable general
conditions, etc. – plus a fee.
The fee is typically calculated
as a percentage of the project
costs, and the exact percentage
can vary widely depending on
the circumstances. The prob-
lem with cost-plus contracts for
owners is they shift almost the
entire risk of cost increases to
the owner. And since the con-
tractor’s fee is a percentage of
project costs, the contractor has
an incentive to drive up costs
to increase its profit.
Despite the allocation of risk,
cost-plus contracts do not give
contractors the right to incur
costs with wild abandon. A
well-drafted cost-plus contract
will contain measures to keep
costs under control. Outside of
the contract, the law imposes
duties on contractors to keep
them from running up project
costs at the owner’s expense.
Some jurisdictions go so far
as to impose fiduciary duties
on contractors working under
cost-plus contracts, but even
where contractors are not fidu-
ciaries, courts require them to
take steps to control costs.
The first duty courts impose
on contractors is to keep costs
reasonable. This means the
contractor should only incur
costs necessary to complete the
job in a competent manner. The
contractor must, therefore, take
measure to control its costs.
The contractor also bears the
risk of costs arising out if its
own defective or inefficient
work. Such costs may not be
passed on to the owner.
The second duty placed on
contractors is to inform the
owner of cost overruns. Con-
ditions change during con-
struction all the time and for
many different reasons. Own-
ers should reasonably expect
changes, but they cannot make
informed decisions about how
to
handle
c h a n g e s
unless
the
c o n t r a c t o r
informs of
the change
and its effect
on
proj-
ect costs in
a d v a n c e .
C o l o r a d o
courts have
held that a
c o n t r a c t o r
who fails to
keep owners apprised of cost
overruns is acting in bad faith.
Both owners and contractors
need to carefully manage cost-
plus projects to keep costs rea-
sonable. This starts with the
contract. The parties should
outline their expectations as
clearly as possible and include
provisions to control costs,
such as the following:
•All costs must be reasonable
and necessary. Although the
law imposes this requirement
anyway, making it explicit in
the contract will help the par-
ties and, if necessary, a court,
know what is required.
• Require an initial estimate
prior to executing the contract.
Circumstances may make a
fixed-price bid impractical, but
a competent general contrac-
tor should be able to provide a
base estimate with the under-
standing that changes to the
design, unforeseen conditions,
owner-initiated changes and
other factors may increase the
cost.
• Where possible, require the
general contractor to obtain
competitive bids from subcon-
tractors. Again, this may be dif-
ficult for some trades to do, but
most should be able to provide
a base bid with the understand-
ing that changes may occur. If
a sub is absolutely unable to
estimate the cost of its scope
of work, the general contractor
should include an allowance
in the estimate and inform the
owner.
• Provide for a change order
process. Change orders, when
handled properly, are an effec-
tive measure for keeping the
owner informed and address-
ing cost increases before they
become a problem. The change
order provision should require
the contractor to submit a writ-
ten change order that outlines
the proposed change and tell
the owner what it will cost. It
should also require the owner
agree to the cost in writing
before the contractor does the
work.
• Require the contractor to
submit an updated sched-
ule of values with each pay
application. This will keep the
owner apprised of changes to
the base estimate as the project
progresses. The owner can see
where the costs have increased
and by how much and can
make informed decision about
the project moving forward.
• Define what should be
included with each pay appli-
cation. The pay applications
should provide backup for the
costs billed. This includes time
cards documenting the work
the GC’s employees and those
of its subcontractors performed
as well as invoices for materials
used in the project.
• Put the hourly rates for the
contractor’s management and
supervisory personnel in the
contract.
• Include a provision that
allows the owner to audit the
project costs after reasonable
notice.
As with any relationship,
the key to a successful cost-
plus contractual relationship is
communication. If the contrac-
tor keeps the owner informed,
and the owner is diligent is
monitoring costs and raising
concerns with the contractor
during construction, a cost-
plus arrangement can work
well. When communication
breaks down and costs over-
runs occur, no one is happy
and the parties are much more
likely to end up in a costly dis-
pute. Proper communication,
including carefully document-
ing what happens during con-
struction, will protect both the
owner and the contractor.
s
T
he real estate industry
has enjoyed record-
low interest rates and
bountiful supplies of debt capi-
tal over the past decade. As
with all good things, now the
question on everyone’s mind
is, when may this be coming to
an end? The feedback or indus-
try whispering is that with
this last up cycle, we are near-
ing or are in the ninth inning.
While we feel this is a bit hasty
and there is still a significant
amount of runway left in this
cycle, we are beginning to see
some winds of change from a
lending point of view.
Generally speaking, com-
mercial real estate financing
is becoming more selective
as lenders are underwriting
to more conservative metrics.
The following reflects our first-
quarter analysis of trends and
nuances impacting the com-
mercial debt markets.
First, banks have enjoyed a
vast resurgence in both capac-
ity and competitive underwrit-
ing. However, recent changes
in the regulatory environment
are now rippling through the
industry. As a result of Basel
III, many commercial real
estate construction and acqui-
sition loans are now classified
as “highly volatile commercial
real estate.” This designation
mandates that bankers increase
reserve allocations associated
with these types of loans. Not
only does this affect the capac-
ity to lend, but it also impacts
the desirability of pursuing
these loans. Ultimately, Basel
III will cause banks to shy
away from riskier asset classes.
The Dodd-Frank regulations
are also contributing to lending
hesitancy as
banks wade
through the
new regula-
tions
that
continue to
roll out. On
the
posi-
tive side and
despite these
r e g u l a t o r y
hurdles, we
see banks are
still remain-
ing active in
commercial
real estate as
ample capital remains.
Second, the agencies remain
active and competitive. The
Federal Housing Finance
Agency recently allowed both
Freddie Mac and Fannie Mae
to increase their lending caps
from $31 billion to $35 billion
due to continued growth in
the multifamily market. The
cap will be waived for certain
affordable projects or under-
served markets. Pricing has
been somewhat wider than in
the past due to inefficiencies in
the market and securitization
process. However, this reduc-
es the likelihood that the two
agencies will have to restrict
deal flow by increasing rates
or narrowing their fairways.
FHA continues to be a stable
resource as it can offer longer
term, fully amortizing loans
with 35- and 40-year terms.
Third, life companies are
coming off another record
year for funding commercial
real estate. The supply of capi-
tal that has been allocated for
2016 is estimated to be at least
equal to last year’s totals if not
slightly more. However, under-
writing
of
certain prod-
uct types has
become more
conservative.
For instance,
some lenders
are under-
writing hos-
pitality assets
based upon
2013
and
2014 histori-
cal metrics,
i g n o r i n g
the banner
year for this
industry in 2015. These lenders
are refusing to underwrite at
what is perceived to be the top
of the market and ultimately
restricting the flow of capital to
hospitality assets.
Office buildings are now
being carefully underwritten
with higher tenant improve-
ment/leasing
commission
reserves and wider debt yields.
With several recent retail bank-
ruptcies and store closings, life
companies have become more
cautious with what used to be
desired anchor stores.
Multifamily loans have
become harder to source due
primarily to the perception of
Denver’s market. Insurance
companies look at Denver’s
larger-than-average pipeline of
new construction while ignor-
ing absorption and household
formation rates, which contin-
ue to exceed supply.
There is good news with
respect to industrial real estate.
Most life insurers are underex-
posed to industrial real estate,
so any nonmarijuana tenant-
ed property tends to be well
received. In general, life insur-
ers are slightly easing off the
throttle, which is the first sign
that this source of funding will
be tougher to secure and close.
Finally, the commercial mort-
gage-backed securities market
has been dormant for most of
2016. The slowdown was due
in part to much higher yield
requirements by bond inves-
tors. Over the winter, we saw
deals getting re-priced at the
closing table by 50 basis points
or more. Even more troubling
was industry experts suggest-
ing that up to 25 percent of the
loans in the pools were being
kicked out by the “B” piece
buyers. Spreads were inordi-
nately blown out and highly
volatile. Recent Dodd-Frank
regulations also have caused
pricing to widen from the
norm. CMBS originators now
have some personal recourse
with respect to complete and
correct information that is
used by the bond investors.
In December of this year, they
will all have to contend with a
5 percent risk retention require-
ment that essentially mandates
these lenders have “skin in the
game.” There also has been a
wave of layoffs in the CMBS
sector, further compounding
woes. Despite these headaches,
CMBS remains a viable source
for higher leverage lending
though the certainty factor is
still a cause for concern. Bor-
rowers will proceed cautiously
here.
What does all of this portend
for the balance of this year?
First, it is advisable to enter the
debt market earlier versus later.
Borrowers should take advan-
tage of a forward rate lock,
which costs virtually nothing
and capitalizes on current rates
and underwriting. Funds are
still widely available, but we
have seen a slow but steadily
narrowing of the fairway from
many sources. Second, we do
not anticipate any dramatic
rises in interest rates, even if
the Federal Reserve pushes up
rates by 25 basis points. Finally,
given the trend toward more
conservative underwriting
across all lending platforms,
borrowers will want to ensure
a solid equity stack to mitigate
the risks in procuring financ-
ing.
s
Jared Berg
Attorney, Sherman &
Howard, Denver
Michael Cantwell
Executive vice
president, CBRE
Capital Markets, Debt
& Structured Finance,
Denver
Shaun Duignan
Senior production
analyst, CBRE Capital
Markets, Debt &
Structured Finance,
Denver
Multifamily loans
have become
harder to source
due primarily to
the perception
of Denver’s
market. Insurance
companies look at
Denver’s larger-
than-average
pipeline of new
construction while
ignoring absorption
and household
formation rates,
which continue to
exceed supply.
