Out-of-pocket Expenses and the Construction Loan

While working as the vice-president of construction and onsite project manager for the construction of four high-end houses in Newport Coast in Southern California…the construction lender could not entirely cover the hard-costs for houses having sales prices of $6.75 to $12.5 million…each house exceeding their loan limits.

We therefore capitalized (owner’s equity) 18-1/2% of the upfront costs of the construction budget, paying out-of-pocket for the concrete work and part of the lumber costs.  The idea here is to postpone the disbursement of construction loan funds to a later point in time during the construction…so as to start the clock for loan interest costs beginning part-way into the total project duration…rather than paying interest on construction disbursements for the entire duration of an 18-month construction schedule.

I also worked for nine years as a construction manager for a bank.  Several savvy single-family builders manipulated their construction disbursements to minimize loan interest payments.  Even though the construction budget lines itemized on the construction loan document have the required funds for each category of the work…the borrower is not required to withdraw/use funds for every budget line-item during the course of the construction.

Some borrowers would complete and sell the new house, close escrow and pay-off the loan…yet still have unused funds in several categories like HVAC, flooring, landscaping, supervision, and builder’s fee…thus not paying interest on the funds leftover in these line-items.  This is a perfectly acceptable approach by the builder/borrower…using out-of-pocket funds for some activities rather than taking disbursements that come with loan interest costs.

The construction lender is required to adequately “fund” the new construction project…but the borrower is not required to use all of the funds itemized in the budget.

Keeping Self-Perform Work Crews Busy

There is a sweet-spot compromise between finding and keeping competent yet economical subcontractors…and maintaining self-performing tradespeople…for the local builder of single-family houses.

I once worked…in my middle twenties…for a home remodeling contractor in a thriving beach community…who maintained an in-house, self-perform crew of six people including himself…with a part-time employee doing occasional rough cleanup…and the usual specialty subcontractors…plumbing, electrical, HVAC, cabinets, drywall, etc.  Our crew did the demolition, concrete, framing, and finish carpentry.     

            The challenge for this remodeling contractor was to always keep enough work out in front of us so we were busy five days a week and occasional Saturdays.  This locally popular remodeling contractor would tell new prospective clients he would accept their project…but it would take three months before the start date.  The other balancing act was to get the subcontractors to show up on time and with full-size crews…as they also had their own challenge of keeping their workforce busy.

Later in my career, I also worked for a large single-family homebuilder doing a mix of “spec” and custom homes in an upscale, economically high-end location…who employed a self-perform crew of 50-plus people in eight specialty trades…plumbing, electrical, finish carpentry, painting, low-voltage, concrete flatwork, tile, and general labor.  This homebuilder subcontracted the other major trades.

The problem for discussion here is that the scheduling and coordination of these varied and different sized work crews…some have 4 or 5 people and others having crew sizes of 10 to 12 people…all having different length durations of time to perform their work on each project…resulted in several projects sitting empty and unmanned for days as crews were shifted daily in the reactive mode of “putting out fires”…in response to never having enough people to go around according to the absolute and overriding imperative of keeping everyone busy.

By employing numerous diverse specialty trades…in order to be both economical and have control over the quality of the work…the builder in this example in essence supervised and managed eight disparate in-house subcontractors with the requirement to give every worker a full-time, 40-hour workweek…otherwise people would leave and find work elsewhere.

The cost for this approach was the loss of overall time.  The number of small clusters of two days here and three days there of projects sitting empty and unworked-on waiting for crews to arrive…added up to most or all of the projects being completed late as much as three to six months.

This particular homebuilder was so committed to this approach that it was unwilling to change…and over time developed a reputation within the community of not being able to deliver their projects on time as promised.

If every person within a large self-perform crew of diverse specialty trades must be kept busy…then what has to give in this arrangement is time.  In the three-way relationship between cost, time, and quality…if cost and quality predominate…then time suffers.

Using subcontractors can be frustrating in terms of controlling manpower and production rates…and in maintaining consistent quality.  But expanding into multiple diverse specialty work crews in-house is not the panacea that it might appear at first glance.

Using Square Footage to Calculate Dollars per Square Foot

I worked in the construction management department of a bank for nine years.  In interacting with realtors, builders, and bank loan officers, the term “dollars per square foot” is often used to describe and differentiate between qualities of craftsmanship, levels of amenities, and geographical location of a particular new house under construction or for sale…all communicated through this one phrase.

During the last five years of working for this bank, I was given the task of evaluating new single-family construction loans in terms of the sufficiency of each construction budget line-item…lumber, framing labor, cabinets, HVAC, flooring, etc.

To create a more accurate method to evaluate each new loan, we produced “cost models” representing each geographical area by taking past recent completed loans in these areas, and dividing each budget line-item by the house square footage to create a bench-mark average consensus of the dollars per square foot for each construction activity and a global number for that geographical area…all in comparable units of dollars per square foot.

While calculating the square footage from the building plans from outside-of-wall to outside-of-wall, plus the internally, in-house agreed-upon convention of 50% for garages and balcony decks, we discovered that our total square foot calculations exceeded by about 10% the square footage given on the title page of the architectural plans.

For a construction management department…within a lender…evaluating the budgets for new single-family construction loans…getting the right dollars per square foot is important to avoid construction loans falling short of funds midway or at the end of the construction…requiring the borrower to come back to the bank for an increase called a “loan modification.”  Loan modifications add an increased element of risk to the overall bank loan portfolio…too many as a percentage of the total number of loans and the bank regulatory agency will note this negatively in its periodic audit…affecting the bank rating and stock value.

So…why this 10% difference in calculating house square footage?  The architect uses “living space”…inside-of-wall to inside-of-wall…as the criteria for calculating the house square footage.

I have never heard the official reasoning behind this approach, but we assumed one reason is that living space is a number that the home buyer can evaluate that leaves out the thickness of exterior and interior walls…unusable space for living.  But another convenient reason in terms of cost to the builder and the home buyer is that an understated house square footage based on living space…reduces city building permit and plan check fees when cities and counties accept this living space square footage number given in the architectural plans.

Because the actual construction costs of concrete, lumber, drywall, painting, roofing, and stucco plastering extend from outside-of-wall to outside-of-wall…a square footage total understated by 10% using living space…will artificially inflate costs per square foot overall and for every budget line-item…making it appear there is more money per line-item in the budget than there is.  From a real estate sales standpoint this gives the house a better appraisal valuation in terms of construction costs and amenities.

In effect, an apples and oranges difference is created which inaccurately skews the talking-point cost appraisal number higher by 10%…unless the caveat is disclosed that the figure given is based on living space…which is almost never done…because few realtors, builders, or bankers make the distinction.

Only a construction person would bother to calculate the real square footage on the plans…rather than accept the architect’s “living space” square footage…and this would only be done for the purposes of uniformity and reality in comparing construction costs in the banking industry…for evaluating new construction loan budgets…and for other interests related to construction costs such as cost estimating.

In closing, an example would be helpful.  Using round numbers…assume a 3,000 square- foot size house in the year 2000 in East Manhattan Beach in Southern California on the inland side of Sepulveda Boulevard, with a lot price of $500,000 (knock-down the old existing house), a projected new house sales price of $1,100,000, and construction budget costs of $300,000.

If we use these figures…the construction costs are $100 per square foot.  The builder, realtor, and anyone else involved in the marketing and sale of the new house will use this number to communicate the quality and amenity level of the construction.

But what if, after calculating the square footage of the new house using the criterial of gross square footage plus the convention of 50% for garages and balconies (they have real costs) instead of living space…the actual square footage is 10% higher at 3,300 square feet.

This new larger number as the divisor in the denominator correspondingly produces numbers throughout the budget and overall that are smaller than derived using the architect’s square footage.  The construction costs per square foot are now $300,000/3,300 square feet… yielding $97/square foot…not $100/square foot.

In a new construction loan budget, if the number for the line-item HVAC is understated by 10% at $18,000 when it should be $19,800 per the cost model…along with every other budget line-item like cabinets, countertops, finish plumbing, and hard surface flooring, for examples, not only is the potential for the need for a loan modification increased by 10%, but the value of the product has been inflated artificially from $97 to $100, in an industry where these comparative numbers are important, valued, relied upon, and evaluated by the consumer.

What is the Sweet-Spot Economically for Self-Perform Crews?

For the high-end, custom and spec homebuilder…there is a sweet-spot compromise between maintaining a mix of economical subcontractors plus in-house, self-perform tradespeople…as opposed to manning the jobsites with the optimum number of workers in order to complete each house on schedule.

I once worked for a homebuilder who maintained on the payroll over 50 people in seven different building trade specialties…plumbing, electrical, finish carpentry, painting, concrete flatwork, audio/video, and general labor…plus independent subcontractors in the other trades such as framing, drywall, HVAC, roofing, and flooring, for example.

The idea here…to self-perform some of the work…was to economize on labor costs, eliminate some profit and overhead that would otherwise go to subcontractors, maintain continuity of ways of doing the work and quality of workmanship, and exercise direct control over the self-perform crews in terms of scheduling and timely customer service repairs.

On the surface, these are in theory all excellent reasons to build and maintain a large self-perform workforce…but in practical application it is very difficult to keep self-perform crews busy for a 40-hour a week paycheck…and at the same time keep all of the jobsites manned at the optimum rate to complete the construction on time…within the tight constraints of a fixed and rigid numbers of detached houses being built at one time.

The duration lengths of time and the move-ons and move-offs for each building trade differ radically over the course of the construction of any house…but is especially complex for high-end luxury houses…spec or custom.

The only way to keep everyone busy yet also fully manned on every jobsite would be to have tradespeople who are capable of working in two or three or even four different specialty trades…which is not realistic.

The result of not being able to fully man each jobsite every day using mostly self-perform work crews…because of their specialization and the differing time durations needed for each construction activity…produces a result that some jobsites will sit empty for several days or more waiting for the needed crew to finish on another of the homebuilder’s houses a few streets away.

What seemed economical at the front-end of building the homebuilding company may not be so economical if construction loan interest costs for not completing houses on time…or dissatisfied customers must wait for their house to be completed two or three months late…as a result of the practice of the impossibility of fully manning every jobsite using predominantly self-perform crews that are inadequate to successfully fill the daily jigsaw puzzle of pieces needed.

Decision Bottleneck for Builders Regarding Interior Design

For the high-end homebuilder doing a combination of custom homes having a homebuyer client, and “spec” houses (short for homes built on the speculation they will attract a buyer)…and having an in-house interior designer or design group of two or more people…the inevitable and almost universal challenge will arise…of the single decision-maker at the top of the company becoming a decision bottleneck.

For the small-sized custom-home and spec builder this is not usually a big problem.  It stands to reason that the owner atop of the homebuilding company makes the aesthetic/artistic decisions regarding the myriad of small and large architectural and interior decision decisions…in coordination with the architect and clients as the case may require…that affect the bottom-line economics for each individual project and thus the success and solvency of the company.

However, when the size of the successful homebuilding company expands…it can reach a point where decisions that are repetitive should be standardized so as to minimize the number of individual decisions to a manageable quantity…otherwise the single decision-maker at the top of the company can quickly become a bottleneck of unaddressed lingering questions and issues that adversely affect the construction schedule.

This is best done in the proactive mode…long before a crisis emerges.

For example, if a medium high-end homebuilder always uses as standard a 3-1/2 inch wide casing around interior doors and windows…and often has wood paneling wainscot from the floor to mid-way up the walls in various hallways and rooms…then the wall-framing returns at each rough door opening should be a minimum of six inches whether or not this is called out on the plans.  Six inches minus 5/8-inch for the thickness of drywall leaves enough space for the door casing and wall wainscot…wood or ceramic tile…for the door casing to fit without it have be cut to a narrower width.  This should be standard knowledge in the field…repeated on project after project without having to ask the question…except in the exceptional cases where the homebuyer or the house itself requires larger width casing.

For a kitchen floor plan layout that is repeated every third or fourth house…the dimensions from the kitchen sink wall and from the kitchen range wall…to the repetitive sized island cabinet… should be standardized…so that the plumber and the electrician already know where to come up through the concrete slab with their pipes and conduit.

If the kitchens all have potfillers (water pipe coming out of the wall with swivel arms and a handle-valve for adding water to pots and pans directly at the kitchen range top) above the kitchen ranges…the height in inches above the rough floor elevation should be standardized.

In secondary bathrooms, the location, size, and dimension in inches above the rough floor for the shampoo niche rough framed opening…should be standardized.  The layout and dimensioning of the various valves for the bathtubs and showers should be standardized.  The width and the length of the inside dimensions of the minimum sized secondary bath should be standardized…so that a 2’-8” doors opening in front of a toilet does not hit the toilet.  The height of sconce lights and the top of mirrors in secondary baths should also be standardized.

These and twenty-five other things can be standardized long before a successful homebuilder grows to the point that the decision-maker at the top of the company becomes an information bottleneck.

In-House Interior Design

One of the pitfalls of having an in-house interior design person or small group within the office staff for a high-end custom homebuilder…is that if many of the architectural decisions and most of the interior design decisions are managed from within the homebuilding company…the homebuilder then also owns the myriad of “internal” RFI’s (requests for information)…which if not addressed in an organized and systematic way can quickly snowball into questions and issues that delay construction operations in the field.

The standard, arms-length arrangement of owner/architect/general contractor divides up the varied duties, roles, and responsibilities into relatively clear lines of demarcation.  Questions from the construction regarding the design plans…or requests for missing information in the plans and specifications…which arise during the course of the construction…are handled through RFI’s from the general contractor to the architect and/or structural engineer, for example…which are then individually monitored for timely response by the general contractor.

RFI’s which have not been answered that might adversely affect the construction schedule are communicated to the owner…often during the weekly owner/builder meeting…the owner then contacting the appropriate design professional regarding the particular question or issue.

The point here is that if the owner (“spec” homebuilder and/or custom homebuilder) is also generating a large portion of the architectural information…moving walls, changing layout, moving interior doors, etc., and all of the interior design information (prior to finding a homebuyer or in coordination with a homebuyer)…then the owner/homebuilder and the designer…parties one and two in the standard arrangement described above…become combined into one unit and there is no outside entity to send questions to other than internally to itself.

The procedure of sending an RFI to the design team and expecting a prompt reply…no longer exists.

In this arrangement…which seems on the surface to be beneficial in some areas such as keeping the artistic decisions consistent with the opinions of the homebuilder and his or her in-house staff…and the ability to better control the homebuyer client without the influence of a third-party, outside interior designer having contrary opinions…must be accompanied by a serious and thorough internal system of policies, procedures, control spreadsheets, and regularly scheduled office staff meetings to insure that field questions are being answered as quickly as they would otherwise be if sent out to an outside design team of the architect and engineers.

Introduction

            There is a reason why we have repetitive problems and mistakes…recurring in building construction…that reason is “geography.”

            No other large-sized finished product is either too big to be transported to its final destination…or on the other hand can easily be rolled-out and driven down the highway, lowered from dry-dock into the water, or fueled-up and taxied down a runway to be flown to an airport.

            Unlike motor-homes, navy aircraft carriers, or 747 jetliners…houses…the smallest sized buildings…are too large to be transported to building sites after they are fully assembled.  Houses are therefore assembled piece-by-piece on their individual sites…and attached to the ground on foundations designed to match the unique size and shape of the structure.

            Transporting larger sized structures such as restaurants, schools, hospitals, high-rise office buildings, and industrial buildings…from an assembly plant to their final destination…in terms of practical logistics is beyond consideration.

            Buildings of all types are therefore assembled on unique building lots spread-out all over the countryside…which in terms of manufacturing debugging and proactive mistake prevention…divides the process into tens of thousands of isolated pieces.  This geographical separation of building construction projects…the breaking up of the mass-production assembly-line…presents some challenging problems unique to the building construction industry.

            Two similar housing construction projects, for example, going up side-by-side, built by different companies, can each be making the same costly mistakes without either one knowing about or being able to benefit from the other’s experience.  The result is that hundreds of thousands of people working in housing construction alone…not counting commercial and industrial building construction…find themselves at different points on the uphill slope of the learning curve, repeating many of the same hard-earned lessons.

            This is one of the fundamental problems still remaining in building construction.  Builders, contractors, and architects do not send memos back and forth regarding mistake avoidance.  Every new building construction project struggles with some amount of assembly-line problems that were encountered and solved months or years ago on other projects…yet this information is locked-up within the geographical footprint of these past projects, and locked away within the closely guarded knowledge and experience of savvy people and companies unable or unwilling to share this information…because of economic competition between companies and competition for employment.

            In my opinion, debugging building construction is the last major area of information remaining to complete the technology of building construction.  Because of the uniqueness of every new building construction project, and the lack of communication in the building industry regarding mistake prevention, the only way to achieve progress in this area is record problems and mistakes one-by-one as they occur, and then pass along this information.

            This is a tall order…a difficult proposition…but it has to begin somewhere and at some time.

            This book is the product of about 42 years of working in building construction…of observing and recording problems and mistakes in a personal debugging effort on the projects I worked on…as a tradesman, assistant superintendent, superintendent, project manager, project engineer, and vice-president of construction…to achieve as near-to-perfect function as I could…to approach the assembly of buildings using the same error-free and smooth process of the mass-production assembly-line.

            My goal here is to pass along this information that I have collected…through a long career of learning from my own mistakes…and observing the mistakes of other people…with the intention of helping people working in the housing construction industry to flatten the uphill slope of the learning curve…to have the foreknowledge of information upfront in their own careers…for the benefit of everyone working in the building industry.