Older apartment buildings can truly be a minefield of potential surprises. That’s why the risk of unanticipated construction costs is especially great when a project involves rehabilitation of an existing structure. But building owners who take on rehab projects can take steps to protect themselves from out-of-control costs regardless of the age of the property.

And for beginners, perhaps the best way to keep cost overruns from swamping your budget is to start with a small property. “I would recommend against cutting your teeth on a behemoth the first time around,” said Dan Haefner, senior vice president and chief information officer of Lane Co. in Atlanta.

Plan ahead to control costs

Once the project is identified, controlling costs starts with an analysis of the needs, resources, contractors, bids, time constraints and operating implications of the project. This analysis should be completed before construction gets under way to avoid trying to “figure it out in the field,” a more haphazard and thus costly approach, according to Tom Flitsch, director of redevelopment at Essex Property Trust in Palo Alto, Calif.

At Essex, all the hard numbers in the project budget are based on at least one and preferably three bids. The lowest bid may be chosen, but isn’t always used in the budget.

“It’s important not to fool yourself by a number,” Flitsch said. “If [one bid] is 30% lower than the average, we will be very circumspect as to why. More than half of the time, we will take that number and try to execute it, but our budget is built on the average, so if the low number falls out, we are not over-committed.”

Essex also considers seasonality, which affects project costs and property operations.

For example, Flitsch said Essex prefers not to schedule swimming pool renovations during the summer, when residents most prize that amenity and contractors command premium rates. Instead, such projects are scheduled after October, so they can be completed more economically and in time for the next swim season, he said.

Construction managers negotiate savings

A rehab project that involves, say, 40 or more apartment units may be large enough to support the services of a construction manager, who represents the owner’s interests on the job site, according to Alan Nevin, director of economic research at MarketPointe, a construction consulting firm in San Diego. Construction managers, who often are semi-retired general contractors, can negotiate expenditures on behalf of the owner and may know of additional ways to cut costs. Such savings can amount to as much as or more than the manager’s fee, which might range from $3,000 to $5,000 per unit in West Coast markets, according to Nevin. Fees of 5% to 10% of the construction budget are also typical, according to Haefner.

An experienced general contractor and architect are also crucial to controlling costs because they can anticipate potential surprises, according to Jim Petty, vice president and chief financial officer of ERC Properties in Fort Smith, Ark.

“They can give you far more information to consider about what may not be visible at the surface level,” he said. “You know you need to fix that hole in the wall, but what’s behind the hole in the wall? That’s the most important thing.”

Charitable giving cuts labor costs

Cost containment should focus on labor because subcontractors today are “buried in work” and “not afraid to make generous profit margins,” said Nevin.

One way to slice labor costs: donate the property’s existing fixtures, cabinets, appliances and the like to a charitable organization such as Habitat for Humanity that will remove those components at no cost to the owner.

“That way, when the contractor comes in to do the new work, he has a clean palette and that makes it easier,” he said.

Nevin also recommended tapping contractor services offered by some big-box home stores (for example, Home Depot, Sears and IKEA). He said these companies often perform work on multifamily or commercial projects as well as single-family home remodeling jobs and that they can be very competitively priced.

He also said some contractors might accept less money if they will be paid immediately upon completion of the job. Contractors may need to borrow money to finance their cash flow, so being paid quickly reduces their costs. Using unlicensed contractors for work that doesn’t require licensed skills (for example, painting and carpet installation) can save money too.

Use fixed-price contracts

Essex relies on a modified version of a standard industry contract to protect against cost increases on any job component valued at more than $10,000, Flitsch explained. The contract stipulates a guaranteed price for the work to be performed, rather than a cost-plus arrangement. That way, the contractor bears the risk of price increases.

“If materials prices increase, that’s not our problem,” he said. “The way we contract the work limits our exposure.”

If the contractor can’t accept the risk, materials can be pre-purchased to lock in the price ahead of time, he added. Essex used that strategy to cope with fast-rising steel costs on a $13.3 million rehab of the interior hallways, elevators and leasing office at a 715-unit apartment property in Newport Beach, Calif. The construction budget contained a 10% contingency, but steel prices jumped 25% during the planning phase of the project, so two orders were placed in advance. The nine-month project was completed on time in April 2005, despite the wettest winter on record in Orange County, and on budget with barely a dent in the contingency funds, Flitsch said.

Fixed-price contracts can eliminate exposure to price increases, but Haefner said they aren’t always the least expensive option because contractors will “build some buffers” into fixed prices to make sure they don’t lose money on the job. Owners who are comfortable with the risk might want to accept a cost-plus arrangement that’s cheaper than a fixed-price contract.

Incentives reward contractor savings

Another cost control strategy is to pay the contractor an incentive to stay under budget. Haefner said Lane has offered such an incentive to the general contractor on a 264-unit condominium conversion in Myrtle Beach, S.C. The $5 million project is expected to wrap up several thousand dollars below budget on construction costs. The contractor will receive a bonus of 25% of the savings.