Developers: how a GMP overrun reaches the equity waterfall

A developer signs a GMP because the lender requires a fixed hard cost number to size the loan. The equity partner signs the operating agreement because that number is in the pro forma. From that day, the GMP is not only a construction contract. It is the assumption that every other number in the deal rests on.

When the GMP moves, the movement does not stay in the construction column. It travels through the sources and uses, into the loan to cost test, into the capital call provisions, and finally into the waterfall where the developer's promote lives. This post traces that path, so the developer knows which construction signals to watch months before the capital call.

The path from change order to promote

Take a fictional $62 million mixed use project with a $44 million GMP, a 65 percent loan to cost, and a $2 million owner contingency held outside the GMP. The equity is split between an institutional partner and the developer, with the developer's promote triggered above a preferred return.

An owner scope change of $600,000 is executed in month seven. It raises the GMP and it draws the owner contingency. Nothing else appears to happen. By month fourteen, three more changes and two allowance overruns have used the owner contingency completely, and the next change is a cost overrun under the loan agreement. The lender requires the overrun to be funded by equity before the next draw. The operating agreement says the capital call dilutes whoever does not fund, and the promote hurdle is calculated on total equity invested. The developer's share of the upside just got smaller, and the cause was a run of decisions made months earlier with no running total.

Two contingencies, and the one the lender watches

The contractor's contingency sits inside the GMP and covers the contractor's risks: buyout misses, coordination, rework. The owner's contingency sits outside, or inside by agreement, and covers the owner's decisions and the design gaps the owner ends up paying for. Check your contract for which fund each kind of cost draws on, because the answer varies.

The lender tracks the owner's contingency as a loan budget line and usually requires consent to reallocate it. The contractor's contingency is invisible to the lender until it runs out, at which point the contractor's overruns become change order requests and the argument begins. A developer who sees the contractor's contingency at 20 percent remaining with 50 percent of the work left has learned something about the next six months of change order negotiation. The pay application will not say that in those words.

The anticipated final cost is the number the lender will eventually ask for

Every loan agreement has a balancing test. The lender compares the cost to complete against the remaining loan and equity, and if there is a gap, the borrower funds it. The cost to complete is the anticipated final cost less what has been paid. A developer who computes anticipated final cost monthly, including pending change orders and projected allowance variances, knows the outcome of the balancing test before the lender runs it.

Cause classification protects the promote

Not every overrun is the owner's to carry. A change caused by a design gap may be recoverable from the architect's carrier, depending on the contract and the facts. A coordination change may belong in the contractor's contingency rather than the owner's. An unforeseen condition is usually the owner's, but the contract sets the rules.

A developer who records a cause on every PCO from the first one has a record that supports the recovery conversation. A developer who records change orders as one list of dollar amounts has a list of dollar amounts. The difference at closeout can be the difference between an overrun the equity absorbs and an overrun that is partly returned. The classification is a judgment, and it belongs to the developer and the owner's representative, not to the contractor who submitted the PCO.

Keeping the construction position on the developer's side

Most developers run a development budget in a spreadsheet or a development accounting system, and the hard cost line in it is updated from the pay application. That is the lender's view of the project. The inside of the GMP, the contingency draws, the buyout results, the allowances and the cause of every change, lives with the contractor.

Costwitness keeps that inside view as the owner's own ledger. It is not the development budget and it is not the draw package. It holds the frozen GMP, the contingencies, the change orders by cause and the anticipated final cost, and raises flags when a threshold is crossed. What the developer does with the flag is the developer's decision.

In the product

Anticipated final cost, Change order register, Contingency ledger. Free tool: Change Order Exposure, Contingency Runway.

Keep reading

Earlier: Owner's representatives: one ledger per owner, one portfolio view for you. Later: University capital projects: GMP oversight across several buildings at once. All articles on by owner type.