Relating Time and Money in Construction
Time and time (no pun intended) again we find that general contractors, when managing a project under construction, place far greater emphasis on budgetary concerns than on schedule. A project manager working for the general contractor will bend over backwards to save a few thousand dollars at buyout or will fight tooth and nail against his subcontractors to prevent cost overruns on a given line item. This, we believe, is the result of 1.) the consistent, industry wide training project managers receive throughout their career placing primary emphasis on buyout and arguing away change orders and 2.) a fundamental misalignment of incentives between the interests of the developer and the interests of the general contractor. There is little that can be done about the first reason, but there is much that a developer may do about the second. However, the developer must first establish what does time mean to them?
Translating time into dollars
Most developers should intuitively understand the costs associated with time, however, even they are not always prone to think in these terms. Neither hard costs nor costs associated with time are necessarily paramount, though our clients who have experienced projects delayed by several months can certainly extoll on their particular pain. That said, by identifying and quantifying the rough translatable cost of lost time, communicating this cost effectively to the entire team and ensuring an alignment of incentives between the developer and the general contractor, this will enable far better decision making on the part of the general contractor and his project team on the ground.
The method to calculate a cost for time this is relatively straightforward. For any given construction project, its proforma should have assumed all of the critical inputs, including but not limited to total cost, a model of the debt and equity financing and the anticipated lease up or sales schedule (when dollars will be received for the product being constructed) based on the anticipated construction schedule (usually plus 30 days). If one assumes a shortened construction schedule of one month, and/or an extended construction schedule of one month, comparing the increase or decrease of cash return to the general partner, then dividing by 30. This will result in a daily rate that can then be utilized as a key performance indicator which in turn can be used to align incentives between the developer and the general contractor. This KPI may also be used to drive internal performance metrics for compensation of the development team or their construction representative.
While this metric can be calculated for a single project, if a developer conducts many similar projects, it is likely best to calculate an average number for two or more projects and use the same number for them all. This will help both internal and external team members maintain a baseline figure in their head for an intuitive understanding of the value of time at any moment, without the need to perform a complex calculation. For instance, for many of the recent multifamily projects our clients have performed, where an average unit size might be between 1,000 SF and 1,100 SF, the number of units ranged from 250 to 400, and rents were around the $2.50 per SF, this daily rate worked out to be $1,000 per day. Therefore, the negative financial impact for a one-month delay to the project was approximately $300,000.
Why is defining a clear value for time in the minds of the project team so critical?
As stated above, it is easy for a general contractor to intuit the financial impact to a project which ges $300,000 over budget. In addition to likely negatively impacting their bonus compensation directly, the stress of having to deliver this news to a client is tangible because a number this significant is likely well above their personal salary or even possibly their net worth. However, delivering a message that the project is delayed for some reason or another does not create the same anxiety (Note: one can say the exact opposite for the reverse, the personal and professional satisfaction of saving a client $300,000 vs. delivering a project early). For example, one of our clients had a project where the power utility refused to finalize their design until the project had broken ground. Once this occurred and the design was completed, the new design included an unbudgeted secondary loop, adding significantly to the cost. After the owner and general contractor negotiated an agreed upon change order for these costs, the general contractor (operating under a Lump Sum agreement) then spent two additional weeks rebidding the work in the hope to obtain a lower cost of $50,000 as this would result in a savings directly to themselves. Meanwhile, this work being in the critical path, pushed the schedule out two additional weeks (at an additional cost to the developer) of $150,000 in lost time.
What about liquidated damages?
Precisely. The concept of creating this daily rate is to account for both early and late delivery. In general, we advise that liquidated damages should not be sought unless a project is delivered more than one month late. However, by instilling the project team with an understanding of the cost of time and creating the inverse of liquidated damages (liquidated savings), this generates greater incentives for the general contractor to deliver early. While most developers would be perfectly happy with on time delivery, the fact is that this rarely happens unless the project team is as focused on schedule from the start of the project as they are on buyout and budget. If the general contractor manages to deliver early, however, this only benefits the developer by generating revenue more rapidly than the proforma assumed. This will result in transitioning to long term financing earlier and higher yields to the investors.
It is up to the developer how they wish to allocate any liquidated savings, however, considering that developers usually hold the general contractor 100% accountable for liquidated damages resulting from lost time, it would only be fair to share the entirety of savings from gained time with the general contractor.
Phased delivery
In the case where a project has a phased delivery, this same calculation can apply. The Daily Dollar rate should be applied for each phase or building via a simple matrix to establish shared savings or penalty based upon the receipt of certificate of occupancy for that phase or building. If phases or units have differing numbers of revenue generating units, these can be adjusted proportionally. See below for an example.
Communicating the value of time
Once the value of time has been calculated and a formula for a bonus/liquidated damages defined, it is not enough to merely rely upon its existence in the contract to incentivize the project team. While also adding direct bonus language into the contract for the superintendent and/or project manager can also be helpful, what is most vital is that this concept is communicated loudly and frequently. This is also why having an easy round number to cite provides a shorthand to the project team to think about their actions and how this might impact, not just the project, but their own bonus. The concept should be conveyed early and often at project meetings with the developer’s team to make sure not just the office personnel, but the boots on the ground understand that their is real money to be made (or lost) through delivering the project early (or late).
Incentivizing internal team members
Likewise, this KPI can serve as one metric on which internal team member compensation may be based. Whether this applies directly to the developer’s owner representative, or more broadly to an. entire project team, by converting the value of time to dollars, incentive compensation calculations become far easier to intuit and calculate. For instance, let’s assume an owner’s representative received a base bonus compensation for the delivery of a $40,000,000 project on budget, but receives an additional bonus for every percentage the project comes in under budget. Therefore, they receive this additional bonus by bringing the project in for $39,600,000. However, if the project delivers six weeks late, at a cost to the project of $420,000, is this bonus deserved? We would contend it is not. However, let’s say the same project is brought in at a final cost of $39,900,000 but it also is delivered five weeks early resulting in $350,000 of positive financial impact, we would contend this additional bonus has been earned.
