How To Track A Construction Budget
Welcome to the Real Estate Expresso podcast, your morning shot of what’s new in the world of real estate investing. I’m your host, Victor Menasce.
On today’s show, we’re talking about the process of budget tracking for construction. When you’re building new construction, your lender is not going to deposit the full loan amount into your bank account. The loan is secured by a mortgage against the property, meaning the lender is only willing to lend against the materials that form part of the property. A pile of lumber sitting in front of the building is not part of the property until it’s installed. We need to track the construction in stages. The lenders call that draws. You put in the foundation, and then, once that’s done, the lender reimburses you for the foundation, and so on, all the way through the entire construction process.
You would think that budget tracking is a fairly simple and straightforward process, but it’s actually not the case. Most institutional construction projects involve a sworn statement of construction. Some lenders require a third-party cost consultant to certify the budget and to certify the construction draws. In the textbook accounting process, you create a budget, you issue an invoice for the line items in the budget as you incur them, you then pay the invoice, and reconcile them against the bank statement and against the invoices. Everything matches up with the budget. Everything works perfectly. It’s simple and straightforward. There’s really a budget and an actual.
But, in the world of construction, we want to hold the contractor and the subcontractors accountable for their work. That means holding back a percentage of the payment until certain milestones are achieved. That holdback is typically 10%. Sometimes it’s 5%. It depends on what you negotiate with the subcontractor or with the general contractor. If a subcontractor invoices ~lets~ let’s 📝 say for $100, you would, by agreement, only pay $90 on that invoice. The remaining $10 is held by the lender until the completion of the project. That 10% retainage is fairly standard in the construction industry.
So you have a situation where your accounting will always show that you’re underspent when you compare the actual spending against the budget. In some jurisdictions, it’s also possible to get a rebate on the sales tax paid on the materials and maybe even some of the sub-trades. So that means you’re going to pay the taxes, pay the sales tax, and then apply for a rebate. Now, you need to track not only the retainage that you attract as a future commitment but then you need to track the sales tax and the sales tax rebate to know where you are in your budget vs. the actual.
Of course, every well-managed construction budget will have a line item in the budget for contingency. That contingency is there to handle surprises that come up in the project and that ultimately must be paid for by the owner. Some of them will be covered by the general contractor, but some are going to be paid for by the owner. And sometimes these cost overruns are the result of maybe material supply chain issues or maybe site work that might end up costing you additional funds.
Now, the problem with most budgeting tools is that they are very simplistic—they track two numbers, the plan and the actual. The needs of the project extend far beyond these two simple numbers. So, let’s talk about the various views that are necessary to properly track a construction budget. Number one, there is the plan of record, we sometimes call that the anchor budget. That number is set at the start of the project, it forms the sworn statement of construction, and it never changes, it is the reference, it is the golden budget, and never changes. And it’s approved by the lenders, with this one statement of construction. And it’s also the budget that the cost consultant will use, as their point of reference when they’re working with the lender, using that as their anchor budget.
Then, there’s a forecast, that forecast would ideally be matching the anchor budget. But in an ideal world, there are no problems, no surprises, and in fact, you wouldn’t even need any of the contingency funds. But in reality, there’s likely to be additional costs that dip into the contingency, and this is where you want to track the actual running forecast of completion.
Once a change is accepted by the lender, or by the cost consultant, you can think of this as a budget revision. It now becomes the current budget. The anchor budget doesn’t change, but now your current forecast becomes your working current budget. Along the way, you might have subcontractors propose additional changes to their line items, and there’s a period of time when these changes or these proposed changes are not accepted. In fact, there could be several days or weeks when you explore alternatives to what the subcontractor is proposing. These changes might be accepted, they might be rejected, or a third alternative might be proposed.
You want to track all of this information unofficially so that you don’t expose it to the cost consultant or the lender. You want to be able to track those internally, so you need a third view, an internal forecast, that may encompass the risk items that aren’t officially part of the budget. Ideally, this column is temporary and should only last for a few days at a time.
The final thing you want to track is the actual cost. But because of all the complexities associated with the holdbacks and potential tax rebates, an accurate calculation is only useful at the end of the project after everything is tallied up and everything is done. So it’s not a very useful measure during the project, and you need an additional column to track your actual cost. But those actual costs need to be adjusted for the calculation of the holdbacks and the tax rebates. And unless you take that step into account, none of your budget reconciliation will work.
So instead of using the two columns that most budgeting tools use, consisting of a plan and actual, a proper industrial strength tool actually needs five columns. There’s the anchor budget, there’s the revised budget, there’s your internal budget that you haven’t exposed yet because it contains risk items, there’s your running actual to reconcile your spending against the budget, and then there’s the final actual which is your retrospective on the project.
As a result, our company has spent hundreds of hours designing and developing custom tools to track all of these different views of a budget that the commercial tools quite simply don’t come close to fulfilling. You can’t use a simple plan vs. actual tool when in fact you’re require five different views of the data at any given point in time.
Hope this is useful, it gives you some insight into how construction projects work as you think about that. Have an awesome rest of your day, make great things happen. I’ll talk to you again tomorrow.
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