Lender construction contingency requirements are almost always written as a percentage of hard cost. The percentage is the one property of a contingency fund that predicts nothing, because it says nothing about who controls the money or what is already lined up to consume it.
What the covenant usually says
A construction loan typically requires a contingency of between three and ten percent of hard cost, sometimes with a release mechanism at defined completion milestones and sometimes with a restriction on reallocating it to other budget lines.
That structure is sensible as far as it goes. It ensures a fund exists, it keeps the fund from being quietly spent on a scope upgrade, and it releases capital as risk retires.
What it does not do is test whether the fund is adequate for this project, because a percentage is a measure of size and adequacy is a relationship between size and demand.
Two projects at the same percentage can be in completely different positions. One has a clean qualifications page, 80 percent buyout and six allowances. The other has eleven exclusions, 35 percent buyout and twenty three allowances, six of them carried against superseded design. Both satisfy a 5 percent covenant. Only one of them is protected.
The covenant is therefore necessary and not sufficient, and the gap between those two words is where most construction loan surprises originate.
The three questions lender construction contingency requirements should add
One. Which fund is being counted. There are usually two. Owner contingency sits in the borrower budget and the borrower controls it. Contractor contingency sits inside the contract price and the contractor controls it, spending it on its own estimating and coordination misses, largely without asking. A covenant satisfied by a combined figure is satisfied by money the borrower cannot direct. The distinction is set out in contractor contingency and owner contingency.
Two. What is already lined up against it. On the day of closing the fund already has claims on it: unresolved allowances likely to land above their carried figures, uncapped exclusions on a site where they are likely to be encountered, unbought packages exposed to market movement, and owner decisions still outstanding. Sum those and the fund either covers them or does not.
Three. What the release schedule assumes. Contingency is consumed unevenly and late. Releasing at percentage completion milestones assumes a linear burn that does not occur, because finishes, commissioning and closeout produce a disproportionate share of late change orders.
Why the burn is not linear
The shape is consistent enough to plan around.
Early work is site work and structure. Site risk lands here, and where a geotechnical report exists the range is fairly narrow. Structure is heavily bought early and moves little once poured.
The middle is enclosure and rough mechanical, electrical and plumbing. Interfaces between trade packages surface here, and this is where scope gaps between packages produce their change orders.
The last third is finishes, equipment, commissioning and closeout. This band produces the highest volume of change orders on most projects, for three reasons: allowances for finishes and equipment resolve late, owner directed changes cluster near the end when the building becomes visible, and closeout items such as training, spares and as built documentation are frequently excluded and discovered at the point they are needed.
A release schedule that returns half the fund at 50 percent completion is returning it before the expensive part of the job has started. That is a structural mismatch rather than a judgment call, and it is correctable by tying release to retired exposure rather than to completion percentage.
A better test than a percentage
Replace the single covenant with a ratio and report it monthly.
The numerator is the owner controlled fund remaining. The denominator is the remaining open exposure, built from the unresolved allowances, the uncapped exclusions, the unbought packages and the outstanding owner decisions, each with a range.
A ratio above one means the fund covers the reasonable high. A ratio around one means it covers the middle of the distribution. A ratio below one means a capital call or a scope reduction is already implied, and the only question is when somebody notices.
The ratio has a property the percentage does not: it moves for reasons. It improves when allowances resolve favorably and when packages are bought at or below estimate. It deteriorates when an exclusion is encountered or an owner decision is deferred again. Each movement has a cause you can name in a monitoring report.
It is also harder to satisfy cosmetically. A borrower can meet a percentage covenant by reallocating a budget line. Meeting a ratio requires either more fund or less exposure, and both of those are real.
The objection to it is that the denominator involves judgment, and that is fair. Sizing an unresolved allowance requires somebody to form a view on where it lands, and two competent readers will produce different numbers.
The answer is that the judgment is visible and the percentage merely hides one. A covenant at five percent embeds a view about how much protection a project needs, formed by nobody in particular about no project in particular. A ratio built from named items embeds a view somebody has to state, source and defend, and a borrower who disagrees can argue about a specific line rather than about the philosophy. Disagreement about a line is progress. Disagreement about a percentage is a stalemate with better manners.
A worked example
Illustrative figures. Not taken from any client project and not a quotation.
A $73 million project with a covenant requiring 5 percent contingency on hard cost of $58 million, so $2.9 million. The borrower reports $3.1 million and is compliant.
The $3.1 million is $1.7 million owner and $1.4 million contractor. The owner controlled figure alone is 2.9 percent, which would not satisfy the covenant if the covenant said so.
Remaining open exposure at month six: unresolved allowances $1.1 million to $1.9 million, two uncapped exclusions $0 to $600,000, unbought packages contributing $180,000 to $420,000, one outstanding owner decision on facade glazing $200,000 to $450,000. Total $1.5 million to $3.4 million, midpoint $2.45 million.
Ratio of owner fund to remaining exposure at the midpoint: 0.69. Against the reasonable high: 0.5.
The covenant reports compliance. The ratio reports that the facade decision and two allowance items decide whether this project needs a capital call, and that both are addressable now rather than in month fifteen.
What to write into the loan documents
- Define contingency as the owner controlled fund only, and say so explicitly in the definition.
- Require the contractor fund to be reported separately as part of the contract price, not as protection.
- Require a remaining open exposure figure, as a range, at least quarterly.
- Tie release of contingency to retired exposure rather than to percentage completion.
- Require quantity caps on material uncapped exclusions as a condition precedent to closing.
- Require the buyout percentage monthly, as a number and a dollar figure.
- Require change orders to be reported by cause, which means requiring the contract to mandate a change order log.
Item one is a definitional change of about fifteen words and it is the most valuable item on the list. Everything else follows from it, and it costs nothing to negotiate because a borrower who understands the two funds has no reason to object.
What we do
We produce the ratio and the register behind it, sourced to the contract documents, in a form a credit committee can read without translation. Every open item is named, ranged and page referenced, and the owner fund is stated separately from the contract fund. We act for owners and capital, never for contractors. The reading is the readiness review, and the short form is the lender memo.
Questions people ask
Is five percent contingency adequate on a construction loan?
The percentage cannot answer that on its own. Five percent against a clean qualifications page and a well bought job is generous. The same five percent against twenty three unresolved allowances and three uncapped exclusions is thin. Adequacy is the relationship between the fund and the demand already visible.
Should contractor contingency count toward the covenant?
It should be disclosed and it should not be counted. It sits inside the contract price, the contractor controls it, and it is spent on causes that mostly never reach the borrower ledger. Counting it inflates the apparent equity cushion by whatever the contractor carried, which is often one to three percent.
When should contingency be released?
When the exposure it was held against has retired, rather than at a completion percentage. Contingency burn is back loaded, because finishes, equipment and closeout produce the highest change volume. A release schedule tied to percentage complete returns the fund before the expensive part of the job has begun.
This is general information about construction contracts and is not legal advice.