Why develop a Project Budget?
Project budgeting is critical to the success of any real estate development project, whether involving new construction, rehab., or the many other development opportunities available to savvy real estate entrepreneurs.
The project budget includes all costs to be anticipated in completing the project as defined by the developer or builder, including an allowance for ‘contingencies’, or unanticipated expenses. No seasoned developer goes forward without a carefully prepared budget; and no bank lends development or construction funds absent an articulated project budget.
Real estate transactions are inherently complex, involve multiple players to be successful, and take place over some period of time, typically months or even years. The project budget is the first round of financial summary of the probable outcome of the venture: If completed as conceived and presented, will the project prove successful, will it be ‘profitable’ to all involved (entrepreneur, investors, and lenders alike )?
In our Urban Rehabber budgeting workshops we prepare a “pro forma” project budget, incorporating all the known facts concerning a project: Hard Costs, Soft Costs, allowance for “surprises”, and probable outcomes based on our analysis. In the end, your objective is to determine the Profitability of your venture and establish Benchmarks for gauging your prospects for Success.
What’s included in a Project Budget?
Putting together a project budget is the first and most important step an entrepreneur takes in assessing the viability of any business venture. Some “good”(product) or service is to be offered for sale in the marketplace. The process is a business initiative, whether establishing a consulting or professional services firm (service), the development of computer software (product, perhaps combined with services), or the manufacture of a new “widget” (product).
Each initiative entails the purchase of goods and/or services, and product development and production costs, and the initiation of some marketing plan designed to “bring the product to market”. In developing the Business Plan which will guide the enterprise organizational needs, market demand and production requirements are taken into account.
Central to the entire process will be the investment of Capital, both “intellectual”and monetary. And once cash is to be put into the mix, Dreams meet Reality. Investors want to know the projected “return on their capital”; bankers want reassurance of the return of their capital; and the entrepreneur wants to know how his or her “capital contribution” (cash, talent and commitment) is to be rewarded. Elaborate linear cash flows are often developed, showing the investments required over time, anticipated income to be earned, and the crossover point when the venture’s income exceeds expenses and Profits are visible on the horizon.
At the end of the day much of this analysis may well be summarized (perhaps“simplified”) in terms of a Budget readily understood by others. All of these analyses and summaries are employed by savvy real estate investors. The outcome, the Budget, summarizes the expense and income prospects for a specific project and always proves to be a clear cut Feasibility Analysis. Will the project make money? Now? Or later? It is the duty of the successful entrepreneur to assess feasibility before proceeding with a project. To do less is to invite failure.
Your Project Budget will be a clear statement of–
- Overall project cost
- Preliminary construction costs (“hard” costs)
- Estimated non construction-related costs (“soft” costs)
- Provision for “unknowns” (contingency)
- Potential for Profit
- Assessment of project feasibility
3 Categories of expense
In developing a budget there are three basic categories of expense. In the industry these categories are referred as “hard costs” and “soft costs” and, interestingly enough often overlooked: “contingency”. Newcomers to the business tend to be so focused on the construction side, and maybe the resale potential, that they overlook both soft costs and contingency allowances. We’ll talk more about figuring “contingency”. For now, let’s understand the industry jargon…
What are ‘hard costs’?
Real estate development initiatives, including single rehab projects, generally entail the acquisition (purchase) of real property and some improvement to the property – new construction, rehabilitation of existing improvements, subdivision or subdivision’s near-cousin, the condominium conversion. In each instance, the real estate entrepreneur proposes to make one or more substantive alterations to the existing real estate and thereby enhance value. The costs of acquisition and the direct costs of construction are generally considered, in the jargon of the business, “hard costs.”
What are ‘Soft Costs’?
The second basic category of expense in a real estate development project is that of “Soft Costs,” all the non construction-related expenses to be expected in completing the project. Examples include: Transaction Costs, Financing Costs (other than interest), Interest, and such other ‘carrying costs’ as insurance, taxes, utilities, etc.
Consider both Hard and Soft Costs in developing your budget
Both Hard and Soft costs must be taken into account by the prudent investor or rehabber preparing to initiate a project of any size – yes, even a single family rehab.
In the end, there are three very good reasons to develop a comprehensive budget for any project. The first reason is that in working up the budget, one is in fact visualizing both the nature and scope of the project, the work to be done; you’re “walking through the job” in your mind and imagination. This is a useful process no matter how experienced the rehabber.
Secondly, the creation of a budget requires analysis. Line item after line item, the rehabber (and hopefully the contractor as well) is studying and quantifying the work to be done. Using “unit pricing”, which we will discuss further, and estimates of the time required to complete the work, by skilled or semi-skilled workers, the estimator is limiting – hopefully eliminating – the “guesswork” so often practiced by inexperienced or unsophisticated contractors and their developer employers.
Thirdly, the analysis will invariably be based on “best case” scenarios or outcomes. As such, these best case outcomes establish useful Targets, or goals to shoot for: “How it ought to go.” And this is important. Without such targets for performance it is difficult to know when or where we’re falling “off the mark”. Absent these targets it is hard to know when to take corrective action.
The budget itself, then, is an immensely important Tool for the Investor or Rehabber. In developing the budget one is visualizing the process and end product (a properly rehabbed property), objectively analyzing the elements involved, and setting the targets (or goals, if you prefer) to be achieved in the successful execution of the project. At the end of the day, we succeed when we use the proper tools for the job.
SOURCE: Budgeting Your Project, 2nd ed. Urban Rehabber Workshop Series.