Understanding The Differences of Cost Types in Construction Projects
When it comes to construction projects, there are two distinct categories of costs that need to be considered: hard costs and soft costs. Understanding hard cost vs soft cost in construction is crucial for effective budgeting and project management. In this blog post, we will explore the distinctions between hard costs and soft costs in construction and how to disburse funds for hard and soft costs.
What Are Hard Costs In A Construction Project?
Hard costs, also known as direct costs, are expenses that are directly associated with the physical construction of a project. These costs typically include materials, labor, and equipment. Hard costs are essential for the completion of the project and are relatively easy to quantify and track.
- Materials: Hard costs include the cost of all materials required for construction, such as concrete, steel, wood, plumbing fixtures, electrical components, and more. These costs can vary significantly depending on the quality and quantity of materials needed.
- Labor: The wages and benefits paid to construction workers, contractors, and subcontractors are considered hard costs. This includes the cost of skilled tradespeople, project managers, and any other personnel directly involved in the construction process.
- Equipment: The purchase or rental of construction equipment, such as excavators, cranes, bulldozers, and scaffolding, falls under hard costs. These expenses are necessary for the execution of the project and are typically calculated based on the duration of equipment usage.
What Are Soft Costs In A Construction Project?
Soft costs, also known as indirect costs, are expenses that are not directly related to the physical construction but are necessary for the successful completion of the project. These costs are often overlooked but can significantly impact the overall budget and timeline. The following are some soft costs you will likely encounter in the course of a construction project.
- Design and Engineering Fees: Soft costs include the fees paid to architects, engineers, and other design professionals involved in the project. These professionals are responsible for creating the plans, obtaining permits, and ensuring compliance with building codes and regulations.
- Permits and Inspections: Soft costs encompass the fees associated with obtaining building permits, zoning approvals, and other necessary licenses. Additionally, costs related to inspections and tests required by regulatory authorities are considered soft costs.
- Legal and Insurance Expenses: Soft costs include legal fees for contract review, insurance coverage, and risk management. These costs are essential for protecting the project from potential liabilities and ensuring compliance with legal requirements.
- Project Management: The cost of project management services, including coordination, scheduling, and administration, falls under soft costs. Project managers play a crucial role in overseeing the construction process, ensuring timely completion, and managing the budget.
- Financing and Interest: Soft costs include the expenses associated with securing financing for the project, such as loan origination fees, interest payments, and other financial charges.
Understanding the distinction between hard costs and soft costs is vital for accurate budgeting and cost control in construction projects. By properly accounting for cost types, borrowers, contractors, and lenders can ensure that all expenses are accurately identified and each party can adhere to their contractual obligation, leading to a more successful and financially viable project.
How Should Hard Costs be Disbursed in a Construction Loan?
Disbursing hard costs is relatively straightforward for construction lenders. They typically release funds to the borrower in a series of draws, based on the completion of specific construction milestones, and validated by an independent third-party inspector. For example, a lender may release funds after the completion of the foundation, framing, or roofing stages. Disbursing hard costs against the construction budget helps ensure that the loan has the necessary funds to cover the ongoing construction expenses.
However, there are risks associated with disbursing hard costs. One major risk is disbursing funds without confirming that the work is completed. Construction loans are predicated on the concept of having “work-in-place” and the construction lender should take the step of validating the work is completed before funds are disbursed. If the work is not completed, or partially completed, and the lender disburses funds the loan is considered “overfunded”. The implications of overfunded construction loans create risks that can potentially lead to a financial loss. To mitigate this risk, construction lenders often require a site inspection, also known as a draw inspection, to observe and confirm that the hard costs being requested are in fact completed.
How Should Soft Costs be Disbursed in a Construction Loan?
Disbursing soft costs can be more challenging for construction lenders. Unlike hard costs, which can be easily verified through physical inspections, soft costs require more documentation and verification. Lenders need to ensure that the borrower is using the funds for legitimate project-related expenses and not diverting them elsewhere.
The risks associated with disbursing soft costs primarily revolve around the borrower and builder’s financial management and project oversight. If the borrower mismanages the funds or fails to allocate them appropriately, it can lead to delays, financial shortfalls, and even project failure. Construction lenders often require paid invoices, unconditional/final lien waivers, and proof of payment on soft costs to mitigate these risks.
Another alternative construction lenders practice is the controlled disbursement of construction soft costs as a percentage that is disbursed in line with, but not to exceed, the percentage of hard costs disbursed. This helps keep the project moving forward and mitigates some risk to the lender. This method can be simple and efficient so long as the soft costs are acceptable to the lender and understood before the construction loan is closed.
In conclusion, understanding the differences between hard costs and soft costs is crucial for construction lenders, borrowers, and builders. While hard costs are directly tied to the physical construction work and can be easier to track, soft costs are non-tangible expenses necessary for the project’s success. Disbursing funds for both types of costs carries its own set of risks, including cost overruns, mismanagement, and project failure. To mitigate these risks, construction lenders must carefully evaluate the borrower’s financial management capabilities, require detailed documentation, and maintain regular communication throughout the construction process.
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