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When You Are Over-Budget: Cost Overruns in Development Financings

When You Are Over-Budget: Cost Overruns in Development Financings

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The real estate market is booming in Poland and other CEE countries, as it has been for the last several years. New investments are being made to develop commercial centers, office buildings, residential properties, and logistic centers.

However, the costs of development and construction have significantly increased in the past year, in particular due to increases in prices of building components and the cost of subcontracted labor resulting from higher labor costs and shortages in the availability of skilled workers. For these reasons, more and more general contractors are proposing flexible remuneration systems.

In such projects, typically between 70 and 75% of the development costs are funded by bank loans and the rest are funded from equity. Sometimes part of the equity is replaced by mezzanine financing. Lenders usually require a fixed budget for development costs. In LMA’s standard Real Estate Development Facility Agreement, a budget must be agreed upon prior to the signing of documents and attached as a schedule to the facility agreement. Compliance with the budget is a crucial covenant under the facility agreement and is subject to regular monitoring by an independent expert. Any changes to the budget require lenders’ consent. 

Banks usually require that the remuneration under the building contracts is fixed as lump sum remuneration (“fixed price turn-key contract”). If the costs on the side of the building contractor increase then the investor needs to negotiate and change the terms of documents. Amendments to the building contract, in particular those that change the general contractor’s remuneration, usually require bank consent. The risk of volatility of raw material prices and labor costs is allocated to the general contractor. However, the general contractor’s objective is to be profitable on the project. If the financial conditions are unfavorable, the general contractor may suffer less damage terminating the construction contract and paying the penalties than completing the construction. Regardless of the provisions of the construction agreements, investors generally have the largest economic interest in completing the development.

In cases when project costs exceed the budget – a situation known as “cost overrun” – the sponsor (or another company from the borrower’s group with a good financial standing, acting as a guarantor) is required to provide additional equity pursuant to a cost overrun guarantee, which is a standard security in real estate development financing. Typically this cost guarantee is limited to between five and 10 percent of the total project costs. Not providing the additional equity within the time period required by the cost overrun guarantee constitutes an event of default, allowing the bank to terminate the facility agreement and make the entire financing due and payable. An event of default could also arise due to a breach of a financial covenant.

In significant cost overrun situations, banks typically conduct additional negotiations with the investors, sometimes also involving general contractors. Typically, the sponsor agrees to provide additional equity and/or the amount of financing is increased, which requires changes to the bank’s credit decision and amendments to the facility documentation, which means additional time and expense, including paying legal advisors. 

There may be additional risk for the banks if the sponsor is providing a non-significant amount of equity (for example, less than five percent), and mezzanine financing is being used, as the sponsor may be less interested in saving the project (although there is always a reputational risk involved). While it is crucial that the financial documentation properly secures the parties’ interests, the personal relationship among the banks and borrowers is also of great importance in resolving such issues. 

It sometimes occurs that the investors are unable to provide additional financing to a project. There are several solutions that can be applied to complete the project in such a case: the general contractor can become a co-investor; the mezzanine lender can assume the investor’s rights; or the senior lender can take over the project.

We believe that with good faith negotiations the parties can often find a pragmatic solution that will allow them to realize their business objectives, albeit perhaps with smaller margins or with some delays. 

As the market and economy are subject to changes, the above issues should be constantly monitored and all market players, including investors, banks, and general contractors, should be reactive and flexible enough to find solutions acceptable for all parties.

By Przemyslaw Kozdoj, Partner, and Michal Kulig, Senior Associate, Wolf Theiss Poland

This Article was originally published in Issue 5.8 of the CEE Legal Matters Magazine. If you would like to receive a hard copy of the magazine, you can subscribe here.

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