Project Controls and Processes for Real Estate Developers
July 22, 2020
By Edward Opall, CPA
One of the most interesting and rewarding aspects of my professional practice has been to work with so many first-rate organizations that consistently and successfully develop and manage portfolios of significant real estate projects. We work with public and private clients of varying sizes who invest in stabilized properties, value-add development projects, or ground-up development. While no company or deal is the same, I have found that successful developers have certain common traits.
Conceiving of a plan, locking in the variables, making the deals, and managing stakeholders defines what a developer does from the outside looking in. Managing the day-to-day aspects of a development project and doing the hard work to realize the goal is what goes on behind the scenes. Multiple layers of staff and management increase the complexity and require formal policies for each specified step. Smaller organizations follow the same principals and determine the extent of formality necessary for their circumstances. Organizations often try to avoid bureaucracy and then suffer the consequences of being too loosely managed. Others create a system so rigid that no one is capable of understanding it, let alone follow it. The following is a discussion of the main activities of a development project and the recommended controls that should be in place.
Business Plan and Financial Projections
Project underwriting is the first essential element of a project. The plan must include a discussion of all the business elements of the project that emphasizes the property’s acquisition, opportunity, market data, construction and entitlement assumptions, proposed schedule, and the financial projections. It is critical that the elements are consistent from project to project and that it provides a baseline for future evaluation of project performance. Many companies have an investment committee, independent of project team leaders, that reviews the underwriting, challenges assumptions, and advises senior management on the go or stop decision.
A key element of the projections is the accurate assumptions of the sources and uses of funds. Initial project cash requirements prior to the assumed equity and debt investors must be determined. The developer’s source of cash for this stage of a project, combined with the needs of other projects and the company’s overhead, is a major limiting factor in a developer’s flexibility. Project delays are common and can happen at any stage. It is important to understand the prefunding cash needs and the “burn rate” of cash during a project.
Companies managing a portfolio of projects need to develop a rolling cash flow projection of all project cash needs. This organizational view allows the developer to forecast the aggregate cash requirements and match with likely sources. Early identification of shortfalls will allow time to change direction on spending or plan for alternative sources of funds.
Successful developers establish a consistent method in executing this very complex stage. They establish a communication process so the team members work with the same parameters and know the current version of ever-changing conditions. They establish policies and control processes for each step in order to avoid omissions and miscommunications. Approval authority within the company for critical project decisions must be established and followed.
Establishing the Project Requirements
The predevelopment phase has limited written scope definition and many variable assumptions. The goal is identify and establish the scope of the project that is sufficient to produce a budget and schedule before plans and specifications are developed. As more information becomes available, they can better assemble project requirements.
- Determine local entitlements needed, such as rezoning or variances, and assess the enthusiasm of local officials in helping the effort.
- Determine other important stakeholders’ requirements, such as utilities, easements, right of ways and traffic impacts.
- Understand all required steps for approval of the project.
Establishing the Schedule
The master schedule memorializes the agreed-upon sequencing and milestone dates for all project-related activities moving forward. Regular communication of changes, obstacles, decisions made and accomplishments are important so that all activities are coordinated. Major elements in the schedule are:
- Applications, review times and approvals of government authorities.
- Complete design production through each phase.
- Preparation and execution of key contracts for the property and customers.
- Incorporating terms of these contacts into the project requirements.
- Bidding and awarding of building contracts.
- Implementation and administering construction.
- Scheduling of completion, turnover, and occupancy requirements.
Establishing Project Cost Estimates
Project cost estimates must be sufficiently thorough in order to make informed decisions about design choices and deals with customers or tenants. Developers engage the help of builders, subcontractors and design professionals in order to prepare conceptual estimates for the preliminary budgets. As the design develops sufficiently, it will be necessary to generate refined cost estimates.
Drawing Review and Value Engineering
A thorough review of the design details at early stages is very important, so that alternative choices can be derived and incorporated into the final working drawings used for construction. This will minimize delays and cost increases in the field during construction. Feedback from builders and trade contractors during this stage provide opportunities to make changes to the design, which will achieve similar or better results with respect to project costs, reliability and operating costs.
An effective and well-orchestrated procurement and buyout process is the developer’s main opportunity to manage costs. It also sets the stage for controlling claims throughout construction. The developer must review and evaluate proposals or bids from qualified contractors and vendors, then negotiate the lowest responsible price, ensuring that the complete scope, detailed milestones schedule dates, and manpower requirements have been included in the purchase. In addition to determining the lowest responsible cost, we recommend that contractors, professionals, and other vendor qualifications be reviewed. The review should include technical experience and past performance, an assessment of their capacity for the subject project, and their financial strength. The decision to select one business over the other should be memorialized in writing.
We strongly recommend that clear company policies prohibiting contractors and other vendors to perform work without an executed contract; at the very least you should have a letter of intent. Allowing a contractor to proceed without the specific terms could set the stage for later disputes. Additionally, without a contract or (at the very least) a letter of intent executed, there would be no contractual indemnification in the event of an accident or other claims that may occur.
In organizations where contracting authority is decentralized, it is important to establish guidelines of binding authority and include that authority within each contract. That way, there would be no confusion during the project. Typically, contracts under a certain value have an appropriate authority level, and the CEO signs larger contracts.
Risk Management and Insurance
Project safety and loss control should be a strict requirement and emphasis of each project. Requiring indemnification language in each contract and verifying your contractors have the required insurance coverage is a time-consuming, but critically necessary element of your contract administration. We recommend that insurance professionals be engaged to advise on the innovative project insurance programs, which can provide needed coverage at the lowest costs. Owner- or contractor-controlled insurance programs, bonding or subcontractor default insurance may be beneficial in certain situations, and we recommend that the plusses and minuses are evaluated at the outset of each project.
Managing the Project Schedule
The project schedule is a fundamental planning tool that communicates the overall project strategy. It defines, sequences and coordinates the activities of each project participant. The scheduling effort should incorporate the work requirements and activities of each team member from the project inception through turnover. During critical phases of the project, weekly team meetings—with formalized minutes—are necessary.
Effective cost control is more than a project accounting system, even though that is an important component. Cost control is a fundamental element of the development process. Managing costs throughout each phase requires anticipation, proactive communication, expertise, accurate reporting, and reliable cost accounting systems. It is important to develop procedures for detailed recording and forecasting of costs, as well as for the evaluation, approval and processing of company commitments and invoices.
Consistent and relevant project cost reports, using standard cost codes, are necessary for effective accounting control. The cost worksheets should be organized in a manner that allows easy evaluation against the business plan financial projections and accounts for the latest view of financial status at the project completion. Lead development personnel should be responsible for the accuracy of the cost report. The accounting staff should provide valuable assistance and monitor the control process, but overall responsibility for the cost reports should rest with key development staff.
Systemic controls over entering invoices against approved contract commitments should be established in the accounting software. The system should include policies that prohibit payments to vendors or contractors without the proper organizational authority.
We recommend that project cost worksheets be reviewed at least monthly, which includes an analysis of line-item variances. It is important to determine the most up-to-date analysis of projected aggregate project costs against projected aggregate project sources. Inadequate contingencies and projected shortfalls need to be clearly communicated timely to senior management so that corrective action could be taken.
Project closeout is a risky element, since aspects tend to be drawn out and many team members have moved on to other projects. This phase needs to be managed carefully in order to preserve hard-earned profits. Turning over space to tenants or customers on time, with all approvals, without penalties, and collecting rent on schedule is the ultimate goal of the development efforts. The organization must implement a proactive planning strategy for closeout early in the project by all team members in order to achieve a more effective result.
Below is a list of important elements of the closeout process:
- Obtaining certificates of occupancy and acceptance by local officials.
- Satisfying all lease or sales contract requirements for acceptance of the space.
- Obtaining necessary written acknowledgement of turn over
- Completion of all punch-list work.
- Obtaining all required documentation and settling all contracts.
- Providing required documentation to construction lender for final draw requests.
All real estate development projects have similar management elements, only differing degrees of complexity. Proper planning and evaluation from the outset will set the stage for success. Effective processes and controls, combined with rigorous analysis and strong communication, will enable the developer to realize its project goals.