Worked example: cost overrun on a ground up project

When the construction loan is fixed, a cost overrun lands on equity, because the debt commitment does not grow to meet it. The same dollars also enlarge the cost basis under an unchanged income stream, so return on cost falls and the margin over completed value shrinks. The arithmetic below separates the funding gap from the economics of the finished building and tests both.

Why undrawn debt and remaining cost set the completion test

The completion funding gap is remaining project uses minus remaining committed sources. The original budget cannot answer that question, because spending to date has already consumed part of every source.

A loan commitment is a ceiling that is funded in draws. Only the undrawn balance is still available to finish the building, and the undrawn balance depends on how much equity went in ahead of the first advance. Where equity funds first, as in the example below, the equity is gone by the time the first dollar of debt is drawn, and the undrawn loan is the only committed source left.

Rebuilding cost to complete starts from a line item reconciliation of budget to actuals. Draw packages that tie each request to lien releases and photographs give the same reconciliation a paper trail, and they are the raw material for restating remaining uses at any checkpoint.

Contingency needs a single definition before the gap is computed. Unallocated contingency is a remaining use that has funding behind it. Contingency already assigned to identified change orders is part of the revised forecast, and counting it a second time as available cash understates the gap.

A cost stress holds the output side fixed. Underwriting that raises cost inputs while leaving price outputs unchanged isolates the effect of the overrun, and the example follows that convention.

“Conservative underwriting assumes higher cost inputs but no change in price outputs.”

Worked example: a $20 million project that costs $22 million to finish

This hypothetical ground up rental project compares a base case with a stressed case. Both use the same sources, the same checkpoint and the same stabilized income. Only the cost to finish changes.

The base budget is $4,000,000 for land, $11,000,000 for hard construction, $2,000,000 for soft costs, $2,000,000 for financing and carry, and $1,000,000 for contingency, a total of $20,000,000. Sources are a $12,000,000 construction loan and $8,000,000 of equity. The loan is 12,000,000 divided by 20,000,000, multiplied by 100, or 60 percent of cost.

At the checkpoint, $12,000,000 has been spent: $4,000,000 on land, $6,000,000 on hard construction, $1,000,000 on soft costs and $1,000,000 on financing and carry. Equity funds first, so all $8,000,000 of equity is spent and the loan has advanced 12,000,000 minus 8,000,000, or $4,000,000. Undrawn debt is 12,000,000 minus 4,000,000, or $8,000,000.

Base remaining uses are $5,000,000 of hard construction (11,000,000 minus 6,000,000), $1,000,000 of soft costs, $1,000,000 of financing and carry, and the full $1,000,000 of contingency, which totals $8,000,000. The base gap is 8,000,000 minus 8,000,000, or $0.

In the stressed case, remaining trades reprice to $6,500,000, an increase of 6,500,000 minus 5,000,000, or $1,500,000. A longer schedule lifts remaining financing and carry to $1,500,000, an increase of $500,000. Soft costs stay at $1,000,000 and the contingency is fully consumed at $1,000,000. Stressed remaining uses are 6,500,000 plus 1,000,000 plus 1,500,000 plus 1,000,000, or $10,000,000.

The stressed gap is 10,000,000 minus 8,000,000, or $2,000,000. The loan is fixed and fully committed, so the gap is new equity. Revised total cost is 12,000,000 plus 10,000,000, or $22,000,000. Total equity becomes 22,000,000 minus 12,000,000, or $10,000,000, which is $2,000,000 above the original $8,000,000.

Cost rises by 2,000,000 divided by 20,000,000, multiplied by 100, or 10 percent. The equity requirement rises by 2,000,000 divided by 8,000,000, multiplied by 100, or 25 percent. The two percentages differ because the debt is fixed and equity absorbs the whole increase.

Both cases assume stabilized net operating income of $1,320,000. Return on cost is 1,320,000 divided by 20,000,000, multiplied by 100, or 6.6 percent in the base case, and 1,320,000 divided by 22,000,000, multiplied by 100, or 6 percent in the stressed case.

Applying an illustrative 6 percent cap rate to both, completed value is 1,320,000 divided by 0.06, or $22,000,000. The spread of return on cost over the cap rate is 6.6 minus 6, or 0.6 percentage points, in the base case and 6 minus 6, or 0 percentage points, when stressed. Value minus cost is 22,000,000 minus 20,000,000, or $2,000,000, against 22,000,000 minus 22,000,000, or $0. That base margin is 2,000,000 divided by 20,000,000, multiplied by 100, or 10 percent of cost.

After repaying the $12,000,000 loan, value left for equity is 22,000,000 minus 12,000,000, or $10,000,000 in both cases. Against $8,000,000 of equity that is 10,000,000 divided by 8,000,000, or 1.25 times. Against $10,000,000 of equity it is 10,000,000 divided by 10,000,000, or 1 times. These comparisons come before sale costs and before any promote, and neither is an annualized return.

One more test shows how much work income would have to do. Restoring a 6.6 percent return on a $22,000,000 basis needs 22,000,000 multiplied by 6.6, divided by 100, or $1,452,000 of income. That is 1,452,000 minus 1,320,000, or $132,000 more, and 132,000 divided by 1,320,000, multiplied by 100, is 10 percent. Income would have to rise by the same proportion as cost.

A funded completion can still erase the development margin

Funding the gap and keeping the margin are separate tests. The first asks whether committed capital covers remaining uses. The second asks what the finished cost basis earns.

Return on cost is the property’s potential net operating income divided by total project cost. An overrun enters the denominator and stays there, so with income unchanged the ratio falls mechanically.

A cap rate is one year of net operating income divided by value. It prices the finished asset and says nothing about a return over a hold. The development spread is the gap between return on cost and the cap rate at which the asset is expected to trade. In one illustrated case, a 5.2 percent return on cost sits against a 3.5 percent cap rate. The gap is not the value created in itself: capitalizing the same income at the lower cap rate produces a value above cost, and that excess is the value created by building.

In the worked example the new equity closes the funding gap and consumes the whole spread in the same step. Cash for the next draw and a positive modeled margin answer different questions, and a deal can pass the first while failing the second.

Where overruns come from, and why delay carries its own bill

New project development carries the risk of construction delays or cost overruns that increase anticipated project costs, along with the risk of obtaining permits and authorizations.

Access to materials and labor is a named exposure as well. When a developer cannot secure either within the expected budget and schedule, results suffer and completion within budget is at risk.

A hotel renovation or development adds a further cost: lost room and meeting-space revenue while space is out of service. A ground up building has no operating income to lose, so delay shows up differently. Stabilization moves out, and every extra month adds interest and carry, which is why the stressed case lifts financing and carry by $500,000 alongside the hard cost increase.

How project stage and capital source change who funds the gap

Visible progress does not show the remaining cash need. A condominium project was halted at 80 percent complete after cost overruns, and the borrower estimated another $10 million was needed to finish. A building that is mostly built can still be a long way from a funded completion.

The source of capital decides whose balance sheet is tested. A sponsor that self-finances bears its own overruns. Where partners supply part of the equity, the open question is whether they have the funds and agree to contribute more.

Lender type shapes the replacement route. Conventional banks were reluctant to finance high-end condominium or hotel construction in one market view, while debt funds could lend to the right sponsor and project at higher cost. A replacement loan therefore belongs in a sensitivity, priced above the original facility.

Higher borrowing is argued to leave a deal more exposed to cost overruns and to permanent loss of equity. The worked example is consistent with that view: with 60 percent debt fixed, the equity bore a 25 percent increase from a 10 percent cost increase.

Mistakes that distort the completion funding gap

Comparing remaining cost with the full loan commitment overstates debt capacity. The commitment includes advances already made. In the example, remaining uses of $10,000,000 face undrawn debt of $8,000,000, not the $12,000,000 facility, and the shortfall is $2,000,000.

Counting contingency twice distorts the gap in one direction, and leaving allocated contingency labeled as available distorts it in the other. A forecast that already includes the change orders the allowance was meant to pay has used that allowance. Adding it again as a remaining source hides the gap.

Raising projected rents alongside costs mixes two stresses. Return on cost of 6.6 percent can be preserved on a $22,000,000 basis only if income rises to $1,452,000, and that income lift needs its own support. Holding income flat shows the cost effect alone.

Applying one percentage to every line misreads the capital call. The cost increase is measured against total cost, 10 percent in the example, while the equity increase is measured against original equity, 25 percent. The dollars are identical and the denominators differ.

Treating a hoped-for partner contribution as committed cash makes the sources and uses balance on paper. Committed and proposed funding belong in separate columns, because the budget only closes if the proposed amount arrives.

Reading a zero spread as a zero loss misses the time dimension. Value equal to cost means equity of $10,000,000 gets back $10,000,000 before sale costs, after a longer hold than the base case assumed.

Checklist questions for a cost overrun on a ground up project

What date anchors cost to complete? A single checkpoint keeps spent dollars and remaining uses from overlapping or leaving a hole.

How much of the loan is undrawn? The undrawn balance, not the commitment, is the debt left in the completion calculation.

Which line items explain the revised estimate? A line by line reconciliation of budget to actuals ties the total change to identifiable work.

How much contingency is unallocated after recognized changes? The answer shows whether the allowance can absorb more or already belongs to the revised forecast.

Which additional equity is committed and which is proposed? That split separates a funded completion budget from one that depends on another contribution.

What do draw documents show about progress? Lien releases and photographs address payment and physical status, which a budget comparison alone does not.

What happens to return on cost with income unchanged? A fixed income isolates the effect of the larger denominator.

How much spread remains over the exit cap rate after the overrun? The spread connects the ability to finish with the value attributed to the finished building.