Rarely is there a real estate project in which something unexpected doesn’t happen. Surprises and changes can add costs to a project, which is why contingency reserves (CRs) are important. In this article, we’ll explore:
- What is a Contingency Reserve?
- How to Calculate Contingency Reserve
- Contingency Reserve Examples
- FHA 203k Contingency Reserve
- Tax Contingency Reserve
- How Assets America® Can Help
- Frequently Asked Questions
What is a Contingency Reserve?
A contingency reserve is money set aside to protect against future unexpected costs. The costs can arise because of change orders or unanticipated expenses. CRs are mandatory on most large real estate projects.
For more information, check out our Complete Guide to Hard Costs and Soft Costs.
What is Contingency Reserve in a Cost Estimate?
Why You Need a Contingency Reserve
Typically, developers create CRs when building or redeveloping a property. The need for a CR increases with the complexity of the project. Labor costs may predominate on small projects, whereas large projects include labor, materials, and fees.
As a project progresses, the required labor and materials can vary from the original budget. For one thing, the price of inputs may change. The amount of required inputs can also change. CRs in the budget help mitigate any cost overages and budget variances.
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Implications of Contingency Reserves
CRs are a warning to investors and owners that problems may develop in the future. For one thing, retained earnings tied up in a CR aren’t available for dividends. Another reason for a CR is to hold money for maintenance and other costs arising from property management.
CR funds often sit in an interest-bearing escrow account. They are available for disbursement pursuant to approved change order requests.
The lender holds any unused CRs in a maintenance and operating reserve. The reserves remain there until the property stabilizes, such as 90% occupancy for 90 days.
Typically, the lender holds CRs separately from any lease-up reserve. A lease-up reserve pays debt service and operating costs while leasing commences.
Most assuredly, lenders will require a CR for a construction loan program. However, loan-to-cost calculations may not leave room for a CR. One solution is for the general contractor to negotiate a cost-plus contract to handle contingencies as they arise.
How to Calculate Contingency Reserve
A contingency reserve is typically 5% to 10% of hard construction costs. You can use your previous experience to calculate your requirements for a CR. You do this by using the formula:
Contingency Reserve = Total Overruns / Total Hard Costs
Obviously, this number is only available from a historical viewpoint. As builders gain experience, they will have more examples from which to draw. A more conservative approach is to use total costs (hard and soft costs) in the denominator:
Contingency Reserve = Total Overruns / Total Hard and Soft Costs
You can short-circuit the calculations by including a standard 5% of hard costs and 5% of soft costs in the detailed construction budget. In complex builds, those percentages can rise to 10% of hard and soft costs.
Another approach is to enumerate typical contingencies, such as subcontractor problems, deadline slippage, equipment malfunction, and additional labor.
Assign the cost of each contingency and then multiply the cost by the probability of occurrence. Finally, add together all the weighted costs to arrive at the required CR.
Contingency Reserve Example
There are two approaches, flat rate contingency and expected monetary value calculation.
Flat Rate Contingency
Suppose a general contractor has experienced an average cost overrun of 10%. On a $10 million project, a CR would amount to $1 million. This would create a total budget of $11 million.
You can sharpen the calculation by using separate percentages for hard and soft costs, and/or a breakdown of materials and labor.
For example, you could assign a 10% contingency for materials but only 5% for labor. Let’s assume that a $10 million budget breaks down to 60% materials and 40% labor.
The total contingency rate would be 10% of $6 million, plus 3% of $4 million, or $720,000. This a mixed flat rate contingency.
Expected Monetary Value (EMV) Example
You can use the EMV calculation for complex projects. It considers different price variations among different inputs. For example, suppose our $10 million project will need $650,000 for concrete.
We estimate a 35% chance that the actual cost for concrete will be $750,000, 50% chance of $650,000 cost, and 15% chance of $550,000 cost. Multiplying each cost by the chance of occurrence and then summing them gives you an EMV of $670,000:
Therefore, you would budget $670,000 for concrete. Naturally, you can repeat this procedure for any number of inputs.
FHA 203k Contingency Reserve
The FHA requires a CR for its 203k program.
Purpose of the FHA 203k Rehab Mortgage Insurance Program
This program insures loans from FHA-approved lenders to finance either:
- The cost of rehabbing of an existing home, or
- The cost of purchasing/refinancing a house and then rehabbing it, all through a single mortgage
The program is perfect when you desire to purchase a home that requires extensive modernization or repair. The homeowner can cover these costs in a single loan rather than resorting to separate acquisition and improvement loans.
Naturally, this solution avoids the high interest rate and balloon payment requirement for a short-term improvement loan. Instead, the 203k program provides insurance for a long-term adjustable-rate or fixed-rate mortgage that covers acquisition and improvements.
The program insures mortgages that include rehab costs of at least $5,000. Importantly, the limitations, fees, and restrictions mirror those of FHA 203b loans. However, 203k lenders can charge additional fees, including:
- Supplemental origination fees
- Fee for preparation of architectural documents
- Higher appraisal fee
- Rehab plan review fee
If your repairs and improvements are less extensive, you can use the Limited 203k program.
Contingency Reserve for 203k Program
Most of the insured proceeds from a 203k mortgage flow to pay the seller or to refinance a loan. However, the lender designates a portion of the proceeds as a 203k contingency reserve. Accordingly, the lender places this portion in an escrow account and releases it as rehab completes.
The 203k contingency reserve covers cost overruns. Typically, the reserve equals 10% to 20% of the projected financeable repair and improvement costs. State regulation and/or property type may affect the amount of reserve.
For example, empty properties lacking utilities mandate a CR of at least 15%. Furthermore, the lender may require CR funds on homes with termite evidence.
If any reserve funds remain after completion, you may allocate them to other projects or pay down the principal.
If you have a Limited 203k, you can use the remaining funds for safety-related and health-related upgrades. Note that the FHA allows the borrower to provide some or all of the CR funds.
Tax Contingency Reserve
Generally, a tax contingency reserve is money set aside to pay possible tax liabilities. In real estate, it is an escrow account that holds money for real estate tax payments. The same account may also hold money for homeowner’s insurance premiums.
Typically, lenders require a tax CR when the borrower shells out a down payment below 20%. The lender requires the reserve because it wants to avoid a tax lien on the property. Tax liens have priority over mortgages when auctioning or selling a foreclosed home.
At closing, the borrower will put down the initial tax CR escrow deposit. This gives lenders sufficient time to pay future real estate taxes. Each monthly payment to the tax CR equals 1/12th of the annual real estate tax bill.
However, the initial deposit depends on the time until the next tax bill is due. The lender can collect a two-month cushion to guard against any sudden property reassessments.
How Assets America® Can Help
Assets America® can arrange commercial construction, refinance, and rehabilitation starting at $10 million with no upper limit! We can include CRs in the financing program we arrange.
You may find it much easier to work with us compared to dealing directly with an institutional source. If you’d like to learn more about the ways we can help, call us today for a free consultation.
Frequently Asked Questions
What is the purpose of schedule contingency reserves?
A schedule CR deals with time added to a project schedule to account for the risk of delays. Since delays are untimely, the CR should contain funds to cover these unanticipated delays. Typically, a schedule CR manages identified risks. Instead, you use a management CR to manage unidentified risks.
How much should you plan for your contingency reserve budget?
The contingency reserve budget should reflect a portion of the hard or total costs for a construction or rehab project. Typically, you should set aside 5% to 10% of applicable costs for your CR. You can use previous experience to gauge the percentage to put aside for your CR budget.
How do I develop a contingency reserve?
You can have the CR included in the loan amount. Alternatively, you can provide the CR yourself, as is the case for some homebuyers. The lender places the CR in an escrow account or savings account until the construction is complete.
How do I calculate contingency reserve given EMV?
EMV, or expected monetary value, is the expected cost of an assortment of contingencies. You calculate it by multiplying the estimated contingency cost by the probability of occurrence. Then, you sum all these estimates to get the total CR.