Construction Costs

Definition of Construction Costs

In the context of commercial mortgages, construction costs represent the total financial outlay required to develop, build, or significantly renovate a commercial structure. These costs encompass every expense from the initial groundbreaking to the final issuance of a certificate of occupancy. Lenders use these figures to determine the Loan-to-Cost (LTC) ratio, which dictates how much capital the bank will provide versus how much equity the borrower must contribute.

Hard Costs

Hard costs, often referred to as "tangible costs," are the direct expenses related to the physical construction of the building. These are typically the most straightforward to estimate but often represent the largest portion of the budget. They include:

• Materials: The cost of raw materials such as steel, concrete, wood, glass, and roofing.
• Labor: Payments made to the general contractor, subcontractors, and specialized tradespeople like electricians and plumbers.
• Site Work: Expenses for excavation, grading, utilities hookups, and landscaping.
• Equipment: Costs associated with renting heavy machinery, cranes, or scaffolding needed for the build.
• Finishes: Interior elements such as flooring, cabinetry, lighting fixtures, and HVAC systems.

Soft Costs

Soft costs are the intangible expenses that are necessary for the completion of a project but do not involve the physical assembly of the structure. These are often incurred before construction begins and continue throughout the life of the loan. Common soft costs include:

• Architectural and Engineering Fees: Payments for blueprints, structural designs, and environmental assessments.
• Permits and Government Fees: Costs for building permits, zoning applications, and impact fees required by local municipalities.
• Legal and Professional Fees: Expenses for attorneys, consultants, and project managers.
• Insurance: Builder’s risk insurance, general liability, and workers' compensation.
• Marketing and Leasing: Costs associated with finding tenants for the commercial space before or during construction.

Financing Costs and Interest Reserves

When dealing with a commercial construction mortgage, the financing costs are a critical sub-category. Unlike a standard mortgage, a construction loan is usually funded in draws. Lenders often require an interest reserve, which is a portion of the loan set aside to pay the monthly interest during the construction phase when the property is not yet generating income.

Contingency Funds

Because construction projects are subject to delays, inflation, and unforeseen site conditions, lenders require a contingency fund. This is a specific line item in the budget—usually 5% to 10% of total costs—reserved for unexpected overruns. Having a robust contingency plan is vital for maintaining the financial stability of the project and ensuring that the mortgage remains in good standing if challenges arise.

Role in Underwriting

For a commercial lender, the detailed breakdown of construction costs is the primary tool for risk assessment. The lender will often hire a third-party consultant to review the "cost to complete" to ensure the borrower's budget is realistic. If the construction costs are underestimated, the project risks running out of funds before completion, which significantly increases the lender's risk of default.