San Diego – With construction costs continuing to climb even as sales prices are expected to plateau in many markets this year, developers face a financial squeeze if their construction financing comes up short.

Lenders and developers are both finding ways to ensure that a deal doesn’t fall through just because of a run-up in construction materials costs or because unexpected problems pop up. Some developments in recent years have been bailed out by the market, in which rising values during the construction phase more than made up for the rise in costs. But with the expected flattening in prices, that outcome may become rare.

No partner in a deal wants to sit down and write checks to cover increased costs, but experts say that if both sides have done their homework and are willing to cooperate with each other, then the extra funding can usually be coughed up – often a bit from each side.

The good news for developers is that lenders have become more willing to write checks to help bail out a project having cost problems than they used to be. “If you have a lender that is turning a deaf ear to what is happening in construction, that lender is likely not going to be around for long” in this competitive market, said Jayne Hulbert, a West Coast multifamily lending expert with Deutsche Bank Berkshire Mortgage, Inc.

The cost challenge

Materials cost increases have been attracting attention for a couple of years, and they are leaving development partners exposed during the trickiest time of the development process. After all, it isn’t just the run-up during the construction period that is a concern; there is the often-long entitlement period to worry about, too, according to Thom Cooley, chief of Federal Housing Administration multifamily underwriting at ARCS Commercial Mortgage Co., LLP.

Cooley, moderating a session on construction financing at Apartment Finance Today’s Developer Conference in March, noted that in October 2005 alone, the cost of polyvinyl chloride jumped 12%. In addition, prices for cement rose 6% and steel prices increased 13% in the past 12 months.

To keep rising construction costs from torpedoing a project, developers must institute aggressive cost-control measures and carefully plan for contingencies that might crop up, according to developers and lenders at the conference.

What worries lenders

Responding to a cost problem requires the buy-in and participation of all parties to the deal, and they should deal with it head-on and right away to avoid long delays that would add even more expense to a project, said Scott McClave, vice president of acquisitions for Irvine, Calif.-based developer Bascom Group.

ERC Properties, Inc., a developer based in Fort Smith, Ark., is usually successful at catching problems early in the process before they create too much of a threat to a project, said CFO Jim Petty. But when problems do occur, “in most cases, everybody [in the development deal] has agreed to share the losses.”

Part of that willingness of almost every deal participant – including lenders – to help out comes from a realization that cost problems are not rare occurrences. “All jobs will have change orders,” said Hulbert.

She warned against the temptation to do too much “value engineering” of a project – making changes in previously selected materials in an attempt to bring down cost. Though some developers said that value engineering can be a deal-saver if done by knowledgeable personnel, Hulbert noted that it can also hurt a project. She recalled one luxury hotel that ran into cost problems, so its developers just changed the exterior – but the changes they made were unsatisfactory and “from an external standpoint, that hotel was no longer luxury,” she said.

Lenders are increasingly taking a team approach to understanding a project’s viability when they underwrite a possible deal. Deutsche Bank considers the strengths and weaknesses of all members involved – the borrowers, other lending entities, contractors and subcontractors. “If the subcontractor is unhappy on a job, the entire project can be shut down,” Hulbert said.

Hulbert also wants to know what insurance, completion bond or other backup a contractor has to show that it will complete the job. Sub-insurance for the subcontractors can also help relieve lender anxiety.

“The thinner you are” – the less liquidity the developer has – the more your lenders are going to want to check into the details of a deal to give themselves confidence in the development team and the project, said Cooley.

Controlling costs

Petty and McClave offered some suggestions for controlling costs.

ERC pre-buys a lot of the equipment and materials it needs so it doesn’t get surprised by costs during construction. The company commits to buy a certain volume of material over the course of a year, or if some developments are far enough along, “we’ll buy the framing material for two or three jobs coming up,” said Petty.

ERC has properties valued at about half a billion dollars stretched across 11 states. But Petty said smaller developers can also benefit from pre-buying. Single-family home builders also often have similar pre-buy arrangements with many suppliers, such as with a regional lumber provider or fixtures provider ERC uses in Arkansas. Petty said that getting prebuying deals can be as simple as requesting them from the suppliers; the worst that can happen is they’ll say no, and you’re no worse off for trying. In addition, sometimes you don’t even need to prepay; the supplier just needs the commitment from you to buy the items and will hold them for you.

The design phase is another important place to control costs, added Petty. He suggested having architects design properties so they can use standard equipment, such as doors, window frames, or plumbing systems.

ERC has also brought some of the trade jobs in-house, so it knows the quality of work it will get and is less exposed to the often-busy contractor market.

McClave added that his company is focusing on stress-testing – running scenarios of how the project might fare if certain variables in the pricing structure were to change.

Bascom also uses performance metrics on construction projects, to make sure progress is being made in a timely manner, he said.