A construction overrun, and the equity waterfall it runs into

Cost above the ceiling does not spread evenly across the capital stack. A construction overrun and the equity waterfall underneath it decide who absorbs the first dollar, and the answer is almost always the common equity, which is almost always you.

What you are actually holding

You have a capital stack with a senior loan, possibly a mezzanine piece, limited partner equity and your own common equity. You have a guaranteed maximum price that the general contractor has signed. You have a pro forma that shows a return on cost and a promote that starts once the limited partners clear their preferred return.

Each of those documents was written by a different party at a different time, and none of them refers to the others. The loan documents assume a budget. The pro forma assumes a total cost. The construction contract guarantees a price for a defined scope of work.

When cost moves above the budget, the three documents do not adjust together. The loan stays at its committed amount. The pro forma is a spreadsheet and adjusts instantly, on paper. The construction contract holds a ceiling that covers less than the budget does.

The difference between those three behaviors is where the money comes from, and it comes from one place.

The construction overrun and the equity waterfall, step by step

Take a cost increase of one dollar above the budget and follow it down.

The senior lender does not fund it. The loan was sized at closing against an appraisal and a budget, at a fixed loan to cost ratio. A cost increase raises the denominator. It does not raise the loan. Most construction loans also carry a balancing requirement, which means the borrower has to deposit the shortfall before the next draw is released, not at the end.

The mezzanine lender does not fund it either. That piece was sized against the same budget and usually sits behind an intercreditor agreement that limits any increase.

The limited partners may fund it, on terms. Most operating agreements allow a capital call. Most also price that capital ahead of yours, at a preferred return, and several dilute the sponsor if the sponsor does not participate pro rata. Some carry a penalty rate that applies only to the non contributing member.

You fund it. Either in cash, or by accepting dilution, or by watching the promote disappear. The promote is the last thing in the waterfall and the first thing an overrun reaches.

The arithmetic is unkind. A cost increase of two percent on total project cost can move the sponsor promote by a much larger percentage, because the promote sits on the thin slice above a preferred return rather than on the whole stack. A small movement in cost is a large movement in the only line that pays you.

Which money the overrun reaches first

Before it reaches equity, a cost increase passes through two funds, and both are smaller than the word suggests.

Contractor contingency sits inside the guaranteed maximum price. It is there for the contractor to cover its own estimating and coordination misses. It is not your money, it is not available to you, and in most contracts anything left in it at the end is shared rather than returned.

Owner contingency sits in your budget, outside the contract price. It is yours and you control it. It is also the fund every change order, every allowance overage and every design addition draws against, so it is spoken for long before it is spent.

The two funds are not added together, which is the single most common mistake a sponsor makes when reading a budget. They cover different causes and only one of them answers to you. That distinction is set out in contractor contingency and owner contingency.

There is a third fund on some jobs, and it behaves differently again. An escalation allowance covers movement in material and labor prices between the estimate and the purchase. It is not a contingency and it is not available for anything else, so a budget that shows it inside a combined contingency line is overstating what is available to absorb a change.

Once owner contingency is gone, the next dollar is a capital call. There is no fund between the two, and no mechanism in the construction contract that creates one. The contractor has no obligation to absorb a cost that falls outside the defined scope of work, and asking it to do so is a commercial conversation rather than a contractual right.

This is why the day the guaranteed maximum price is signed is the day your exposure is at its most measurable. Every document that defines it exists, nothing has been spent, and every open item is still a position rather than a claim.

A worked example

A project with a total cost of $84 million. Senior loan at 65 percent of cost, so $54.6 million. Limited partner equity of $26.4 million at a 9 percent preferred return. Sponsor common equity of $3 million, with a 20 percent promote above the preferred return.

Construction cost runs $4.2 million above budget, which is 5 percent of total cost. Owner contingency covers $1.6 million of it. The remaining $2.6 million is a capital call.

The senior loan does not move, so the whole $2.6 million is equity. If the limited partners fund it at the same preferred return, the preferred return stack grows and the sponsor promote starts later and smaller. If the sponsor does not participate pro rata, the sponsor interest dilutes as well.

A 5 percent movement in cost has removed most of the promote on an $84 million project. The building is still built, the loan is still serviced, and the only party materially worse off is the one that carried the least capital.

What to do before you sign

1. Write your budget and the contract price side by side and mark every line that sits in one and not the other.
2. Separate the two contingencies on the page and never show a combined figure to an investor.
3. Read the balancing clause in the loan documents and establish how many days you have to deposit a shortfall.
4. Read the capital call section of the operating agreement and model the dilution at a 3 percent and a 6 percent overrun.
5. List every allowance in the contract price with the figure carried and your own estimate of the realistic landing point.
6. Establish the total of scope that is priced from an estimate rather than an award, because that number can still move.
7. Fix the pricing basis for change orders before signature, since afterwards there is no competition left.

Seven items, most of them answerable in an afternoon from documents already on your desk. The review packages set out how much of this a third party can do for you and in what time.

What we do

We read the guaranteed maximum price against your budget and tell you, in dollars, how much of your contingency is already committed on the day you sign. The output is a register of open exposures ranked by value, with the page reference behind each one. It is written for the person who has to explain the number to a partner, which is why we also work with owner representatives and lenders on the same documents. The starting point is usually the readiness review.

Questions people ask