Real estate investments often involve construction (Project), such as ground-up development, renovation, or tenant improvements, and a heavily negotiated issue in a joint venture relationship is how and to what extent Project cost overruns are allocated. This article provides a brief overview of some of the issues that arise when determining allocation of responsibility for Project cost overruns where a Project is owned by a joint venture (the JV) that is: (i) between a majority investor (Investor Member), with a capital interest of 90 percent or more, and an operator/developer (Operator Member), with a capital interest of 10 percent or less (collectively, the Members); and (ii) is governed by a joint venture agreement (the JV Agreement).
WHAT ARE COST OVERRUNS?
Put simply, for purposes of a JV, a cost overrun occurs when the construction costs (or a particular category of construction costs) exceed the budget (or the line item of the budget intended to cover a particular category of construction costs) approved by the Members. But there are many variations. Thoughtful consideration may be required to determine the appropriate treatment, both in terms of initial payment responsibility and potential reimbursement, of a cost overrun, depending upon, among other matters, the type and cause of the relevant cost.
Interplay with the GMP construction contract
One may wonder why the problem of cost overruns is not solved by entering into a “GMP” (i.e., guaranteed maximum price) construction contract with a general contractor. Won’t the general contractor pay for all the cost overruns? The short answer is no.
There are many costs that may not be the responsibility of the general contractor. For example, most GMP construction contracts contain certain specified exceptions to the GMP (e.g., for differing site conditions or changed conditions) and provide for “allowances” for certain line items (e.g., countertops), which function as mere estimates because the owner has not yet made a decision (so that actual amounts may be more or less than the allowance and the decision is not subject to the GMP). It should also be noted that the GMP only covers the cost of construction, and what that includes is a point of negotiation.
Some development costs simply may not be expected to be paid by a general contractor (e.g., fees of design professionals, property taxes, utilities, insurance, debt service, permits, and leasing costs—sometimes until completion and sometimes until stabilization) and therefore not part of the GMP even though they can result in a bust of the overall JV budget. Some costs that Members might assume are in the GMP are not, or were negotiated not to be, with that change in terms not being made clear to everyone involved. In addition, the GMP construction contract typically includes requirements for the JV to have certain types of insurance that will be a Project cost not reflected in the GMP. Further, the GMP will often be increased based on changes required by review and inspection by the authority having jurisdiction over the work, normally a building safety department. And, of course, there is always the possibility that the general contractor might breach its obligations or not have the wherewithal to fund its share of the overruns, resulting in even more overruns for the JV.
For all of these reasons and more, the Members in a JV cannot solely rely on the general contractor to pay for cost overruns pursuant to the GMP construction contract.
Determination of cost overruns
There are different ways to determine cost overruns in a JV Agreement: (i) line item versus aggregate basis; (ii) forward versus backward looking test; (iii) contingency and line item savings; (iv) original budget; and (v) balancing calls.
Cost overruns may be determined on a line item basis (with reference to each line item category) or on an aggregate basis. The Investor Member typically prefers a line item determination—especially for large construction projects—so it can keep closer tabs on the deviations between budgeted and actual costs. This approach serves as an early warning system alerting the Investor Member that the Project may require “value engineering” or that it may be advisable to obtain some security from the Operator Member to secure its likely overrun obligation.
Cost overruns may also be determined either based only on the costs incurred to date (a backward looking test), or based on both the costs incurred to date plus the costs reasonably anticipated to be incurred (a forward looking test). For example, assuming cost overruns are determined on a line item basis, if only 20 percent of a particular category of the work has been completed but 60 percent of the budget line item applicable to that category of the work has been spent, then there would be an overrun under a forward looking test (to the extent the projected remaining cost to complete the particular category of the work exceeds the unspent portion of the budget line item for such work). But, with a backward looking test, there would be no line item overrun until the full amount of the line item has been expended.
In the battle against avoiding cost overruns being funded by the JV or its Members, the first line of defense is the GMP construction contract (but as discussed above, there may be many reasons why the general contractor is not responsible for the cost overrun). The next lines of defense are: (i) the contingency line item or items (often, if not usually, there are separate contingency line items for hard costs and soft costs); and (ii) if cost overruns are determined on a line item basis, line item savings. Many JV agreements will indicate that a cost overrun does not exist to the extent it is covered by contingency or line item savings. For simplicity, we will assume that any line item savings are added to the applicable contingency line item so that we can focus on contingency without referencing line item savings.1
In all events, cost overruns should be determined and measured by reference to the originally approved budget, subject only to budget amendments to reflect truly discretionary changes in the scope of the Project.
The Investor Member will typically insist that any balancing calls by the construction lender be treated as cost overruns and funded by the Operator Member (subject to final reconciliation upon completion of the Project).
CLICK HERE to read the full article, which was originally published in ALI CLE’s The Practical Real Estate Lawyer.