How much contingency belongs on a conversion before it is simply a construction bet?

Question

Take a 300,000 gsf 1970s office tower being marketed for conversion, with a sponsor deck that reads roughly like this. Acquisition at $60 per gsf, so $18M. Hard costs at $230 per gsf, so $69M. Soft costs at 18 percent of hard. Total near $100M before closing costs. The deck shows 65 percent efficiency, so 195,000 net rentable, 240 units averaging 810 sf. That is about $416k per unit all in. At a 5.25 exit cap that needs roughly $21,800 of NOI per unit, call it $2,900 gross monthly, which is $3.58 per net sf. That is an aggressive rent for the kind of submarket these towers usually sit in, though the best building on the block can sometimes get it. The problem is the contingency. A sponsor like this carries 5 percent on hard costs and nothing on soft. On a conversion of a building nobody has opened up yet, 5 percent reads like a typo. A careful underwriter would want 12 to 15, but at 15 percent a deal like this does not clear a normal hurdle at all, which says either the contingency assumption is wrong or the deal is. What are people actually carrying on conversions, and which line items are the ones that blow through it?

Rena Expert · Accepted Answer

Split the contingency into two, because they behave differently. Design contingency covers the gap between a set of schematic drawings and a fully coordinated set, and on a conversion at pre-GMP stage it's commonly carried at 10 to 15 percent of hard cost, burning down as drawings complete. Construction contingency covers unknown conditions and change orders once a price is signed, typically 5 to 10 percent depending on how much destructive investigation happened before pricing. A sponsor showing a single 5 percent number on an unopened building is either carrying a design contingency inside the trade allowances without saying so, or they haven't got a design contingency. Ask them to show the estimate line by line and identify every allowance, because allowances are the place a soft budget hides.

The items that break conversion budgets in practice: curtain wall or window replacement, which can move a budget by tens of dollars per gross square foot on its own; vertical riser and shaft creation, which is where structural reinforcement and slab coring costs appear; egress, since a second stair or pressurization requirement discovered in code review is expensive and hard to design around; and hazardous material quantities that come back higher than the survey estimated. Note that only the last is truly unknowable. The first three are knowable with enough pre-purchase work, which is why the amount of investigation done before pricing should drive what contingency you demand.

You're also missing contingency on time. Add carry sensitivity, because a six month delay on a $70M construction loan is real interest plus extended general conditions plus a leasing season, and none of that touches the hard cost contingency line.

Your instinct that the deal fails at 15 percent is useful information about the deal. Plenty of these don't pencil, and the discipline is in saying so. Before you conclude, though, run the efficiency sensitivity @nataliehsu raised. If 65 percent is aspirational, the rent needed at $3.58 climbs, and no contingency assumption saves it.

nataliehsu · Answer

The 65 percent efficiency is the number I'd chase before the contingency. On a deep-plate seventies tower with a big central core I've seen conversions land closer to 55 to 60 once corridors and the new risers get drawn properly. At 58 percent you lose about 20 units and the whole thing moves.

sonia_alvarez · Answer

Construction lenders generally want their own contingency sized independently of the sponsor's, plus a funded interest reserve for the full term with a stress run on the delay case. If the sponsor's 5 percent is the figure in the loan model, ask whether the lender has already required a higher number and the equity is being shown the rosier version.

hannah_west29 · Answer

Running the same numbers at 58 percent efficiency: 174,000 net rentable, 215 units at 810 sf, and total cost barely moves because hard cost is driven by gross area, so cost per unit goes to about $465k. At the same 5.25 cap that is $24,400 of NOI per unit, roughly $4.00 per net sf in rent. That is a different building in a different market. The efficiency assumption is worth more than the entire contingency argument.

bmoreno23 · Answer

What is efficiency measuring exactly? Rentable divided by gross, so the losses are corridors, stairs, elevators, and mechanical rooms?

raj_mehta14 · Answer

@bmoreno23 that is it, and in an office building the core was sized for office elevatoring and office bathrooms, so the project carries a core built for a use that is no longer going there. @dpatel_re separate question, is there a completion guaranty and who signs it? If a single purpose entity with no balance sheet is the guarantor, the cost overrun risk sits with the equity regardless of what the contingency line says.

dmitri_248 · Answer

And read the unknown conditions clause in the GMP. A guaranteed maximum price on an existing building usually carves out concealed conditions, so the guarantee applies to everything except the risk the building was bought for. Some contracts cap the carve out with a shared savings and shared overrun band. Which version they signed is worth more than the contingency percentage.

priya_n21 · Answer

Nobody has questioned the $3.58 rent yet. In a submarket where that number is aggressive today, it has to be achievable in 20 months by 240 units all delivering at once.

How much contingency belongs on a conversion before it is simply a construction bet?

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