Ask a Real Estate CPA - What About Hard and Soft Costs in Construction?
Builders and developers ask us about hard costs and soft costs frequently. Here's a quick primer along with some of our more common questions & answers:
What are hard costs and soft costs in construction?
Let's start with the basics. Put simply, hard costs are expenses directly related to the project or development. Typically these are tangible costs - materials, labor, landscape, site, etc. Being tangible makes hard costs far easier to estimate and track.
Soft costs are pretty much everything else loosely related to the project. Examples of soft costs include design fees, surveys, permits, marketing, post-construction expenses, and even some certifications. Because soft costs are indirectly related to the project, forecasting is a bit trickier. For instance, some soft costs may be split across multiple projects or partially counted operating expenses.
What is the typical range or percentage of the overall project budget that is allocated to hard costs and soft costs?
Most hard and soft costs are associated with a single project, making them direct costs. But not all project-based costs are direct. Indirect costs, typically those associated with running the business, can sometimes be attributed to project-specific work, muddying the waters.
On most project estimates, around 70-80% of the entire budget will be allocated to hard costs like labor and materials, while the remaining 20-30% will be allocated to soft costs.
Are there any specific challenges that arise during this estimation process?
Because hard costs are largely quantifiable, they can be estimated with ease. The most challenging aspect of estimating is the intangible and non-specific nature of soft costs. In general, soft costs are much harder to anticipate because they can be incurred through the entire life of the project and can come from out of nowhere. Post-construction costs in particular give people a lot of fits in due to unpredictability and fluctuating costs associated with an uncertain timeline.
The soft cost bucket often ends up as a hodgepodge of tax deductibility. Some costs classify as business expenses, others operational expenses, and some come with tax credits (LEED certification). The best strategy for handling soft costs, particularly when it comes to taxation, is to tag in a real estate-specific CPA who can dramatically improve the estimation process.
Are there any industry benchmarks or guidelines that can help construction professionals in soft cost and hard cost estimation?
The key to forming an effective project estimate is a well-defined project plan that accurately defines scope and breaks work down into predictable tasks. Consulting a body like the American Society of Professional Estimators (ASPCE) or the Association for the Advancement of Cost Engineering (AACE) helps assign confidence levels to each category of work, ranking them from least to most reliable.
The ASPE lists out the activities, uses, accuracy, and common estimating (e.g. bottom-up) methods used to move from a 50,000 ft view down to ground-level accuracy.
Are there any strategies or best practices that you would recommend when it comes to estimating hard costs and soft costs?
Start with experience. The more experience you and your team have with a given type of construction, the better your estimates will become. That extends to CPAs as well. Making tax-conscious choices early and setting up a chart of accounts with the end in mind produces better, more predictable results in the long run.
Next, prioritize all hard costs. Having a prioritized list will help make budget adjustments easy when unplanned expenses arise.
What are the typical subcontractor fees incurred?
The most common and obvious subcontractor fees incurred on a project will be labor fees and materials fees. Labor will be specific to the project, such as plumbing and carpentry, and is typically calculated based on hourly rates. Subcontractors typically charge for the cost of materials, equipment, and supplies needed to complete their part of the project as well. Also look for subs to markup their services to cover other expenses.
Other somewhat common fees include mobilization to cover the sub’s resource movement, change fees for extra work or modifications to the initial scope, and fees associated with obtaining permits, inspections, and other certifications necessary for their part of project.
In general, subcontractor fees can vary greatly depending on many factors such as size and complexity of the project, and it can be valuable to obtain an estimate of the subcontractor’s costs during the negotiation process. Feel free to tag in your real estate CPA here as well to retain a clear view of budgets and potential tax implications.
Hard and soft costs are essential to understand as a real estate developer or builder. Without the help of an experienced real estate CPA, misunderstanding hard and soft costs can take large chunks of revenue off the P&L or even put the project in the red.
Part of every soft cost forecast should be a margin of error to account for overruns. How much overrun budget to set aside will depend on the experience and confidence of whomever is creating the project budget. We tell real estate developers and home builders that cost estimation is huge example of measure twice, cut once. And never be afraid to involve experience. A seasoned real estate accountant or estimator can be more than worth their fee.
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