The construction cost section of a multifamily development pro forma is where the most consequential financial assumptions are made and where the most costly errors occur. A pro forma with accurate revenue assumptions but underestimated construction costs will produce a project that performs well on paper and poorly in execution, a situation that is common enough to have a name in the industry: the “pencil deal” that only works if you sharpen the pencil wrong.
Building a realistic construction cost section requires understanding what categories of cost to include, how to handle contingency, and how to calibrate the budget against current market conditions rather than the conditions that existed when you underwrote a comparable deal three years ago.
The Hard Cost Budget
Hard costs are the direct construction costs, the GC’s contract, including all subcontracted work, materials, labor, and the GC’s general conditions, overhead, and profit. Hard costs are the largest single line item in most multifamily development budgets and the one with the most variables.
The hard cost budget should be built from a current market estimate, either from a preliminary GC pricing exercise or from a construction cost consultant’s estimate calibrated to current local market conditions. The most common error in hard cost budgeting is using cost data that is stale: a budget assembled from a GC’s estimate on a project bid 18 months ago, in a market where construction costs have increased 12% since that estimate, will understate hard costs by 12% before the first change order is written.
For early-stage pro formas before a GC estimate is available, use a per-square-foot cost range calibrated to the specific project type and market, not a national average. Wood-frame low-rise in El Paso has a meaningfully different cost basis than wood-frame low-rise in Seattle, and using Seattle costs for an El Paso project produces a pro forma that overstates the development cost; using El Paso costs for a Seattle project understates it. Both errors lead to bad decisions.
Structure the hard cost budget with enough line item detail to be meaningful: site work, concrete, structural steel, rough framing, waterproofing and moisture management, roofing, exterior windows and doors, rough MEP, insulation, drywall, interior doors and hardware, millwork, flooring, painting, finish MEP, elevators, fire protection, signage and specialties, landscaping and hardscape, and general conditions as a separate line. A hard cost budget with fewer than 15 line items is not providing enough granularity to manage.
Contingency: The Line Item That Determines Whether Your Budget Is Honest
Contingency is the most politically charged line item in a development pro forma. Lenders want to see it. Partners and equity investors want it minimized. And developers who are trying to make the deal pencil are tempted to reduce it below the level that honest risk assessment requires.
The appropriate contingency depends on where the project is in design development and how well-defined the scope is. For a project with full construction documents that have been coordinated across all disciplines: 5% of hard cost is a reasonable contingency for well-documented work. For a project with schematic design or early design development documents: 10% to 15% is appropriate, because the gap between what the current documents show and what will be in the construction documents contains unknowns that will become costs. For a project with a feasibility-level program sketch: 15% to 20% is not excessive.
A contingency that is sized to make the deal work rather than to reflect the actual uncertainty in the budget is not a contingency, it is a number that will be exhausted before the project reaches certificate of occupancy, at which point the developer will be negotiating for additional equity or a loan modification that the lender did not anticipate at closing.
Soft Costs: The Line Items Most Commonly Missed
Soft costs are the non-construction costs of development, the architectural and engineering fees, the permits and fees, the financing costs, the legal and accounting costs, the marketing and lease-up costs, and the developer fee. Each of these categories contains line items that are commonly missed or underestimated in early pro formas.
Architecture and engineering fees for a complex multifamily project run 6% to 10% of hard cost. Early pro formas that use 4% produce a budget that will require upward revision during design engagement.
Permit and impact fees have grown substantially in many markets. Seattle’s permit fees for mid-rise multifamily can reach several hundred thousand dollars. Impact fees in suburban markets, transportation, school, parks, can add $5,000 to $20,000 per unit in markets that assess them. These are knowable costs that should be researched specifically for the project’s jurisdiction before the pro forma is finalized.
Financing costs include the construction loan origination fee, the interest reserve, the lender’s legal and processing costs, and any construction period insurance costs that flow through the loan. The interest reserve, the most significant financing cost line item, should be calculated based on the actual anticipated draw schedule and the current construction loan interest rate, not as a rough percentage of the loan amount.
Developer fee is the line item that generates the most discussion in ownership structures. The developer fee represents the development sponsor’s compensation for finding, entitling, and managing the development process. It is a legitimate project cost and should be included in the budget. The amount varies, typically 3% to 5% of total project cost for conventional market-rate development, with higher percentages allowed for LIHTC affordable housing projects under the applicable program rules.
Stress-Testing the Budget Before You Commit
Before committing to a land purchase or equity raise based on a development pro forma, the construction cost section should be stress-tested against two scenarios: a 10% hard cost increase and a six-month schedule extension. These are not catastrophic scenarios, they are common departures from initial projections that a resilient development structure should be able to absorb.
If a 10% hard cost increase or a six-month schedule extension would make the project infeasible, would drive returns below the minimum threshold required for the equity, would exhaust the contingency and require a loan modification, or would prevent the project from servicing its permanent debt, the project as structured is more fragile than a well-capitalized development program should be.
Innergy Integral’s development advisory practice includes pre-commitment pro forma review that assesses construction cost budgets against current market conditions and stress-tests the budget structure before the sponsor commits to a land purchase or equity raise.
Related: Multifamily Development Services · Multifamily Construction Costs · Multifamily Development Timeline · Development Advisory Guide
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