Managing risks when funding construction projects

From benchmarking to managing inflationary risk and improving business efficiency and processes, there are many reasons why construction businesses use cost data to improve project performance. But this sector is not the only one to use cost data strategically. Here we outline how, and why, the finance sector can use cost data when making decisions about which contractors to lend capital to.

Benchmark Against Historical Data

Cost data from past projects can help development finance companies compare proposed costs with historical data and industry benchmarks to identify potential over or underestimations. Some companies employ quantity surveyors in-house for this process, to prevent projects from being funded on overly optimistic budgets, which could lead to financial strain later.

Identify risk

Is labour harder to source in a particular area? How easy will it be to transport materials there? Cost data helps to ensure that it’s easier for investors to identify and anticipate potential cost drivers that could be prevalent in specific regions or locations. For example, it could be harder to transport materials to a remote part of the Highlands, or areas with a higher flood risk could attract higher insurance premiums.

Access to this information means development finance companies can identify the most volatile areas and mitigate the impact of cost drivers with flexible financing that accommodates potential variations. It can also assist with building contingencies into contractors’ budgets to buffer against unexpected costs, while also reassuring other stakeholders and investors about the project’s resilience.

Demonstrate due diligence

Cost data is an important part of demonstrating due diligence to reassure stakeholders and investors about the resilience of the project. This could involve verifying that the projected costs for materials and labour align with construction cost indices and forecasts, which take market variables and economic conditions into account. In addition, funders might stipulate that contractors use NEC3 contracts; these use Price Adjustment Formulae Indices (PAFI), part of BCIS CapX, to calculate the impact of inflation. This helps to prevent under-budgeting and reduces the risk of the contractor defaulting or failing to complete the project. Cost data can also be used to justify costs for developments and improve the accuracy of cost projections.

Gain insight and help to steer project’s efficiency

In ongoing or previously funded projects, cost data can be used to evaluate operational efficiency, identify patterns of overspending and give lenders an insight into the overall health of the industry.

This helps to equip development finance companies with the knowledge they need to recommend operational improvements for new, or existing projects, that are aligned more on a ‘should cost’, rather than ‘would cost’, principle. It could also be used to verify the contractor’s proposed rates per unit for elements of their work, or labour rates.

Inform loan structures and terms

Cost data can help funders ascertain the specific funding requirements for different stages of the projects. This means they can structure loan terms based on certain criteria. For example, they might structure loans in stages, to deliver funds that align with project milestones, ensuring they’re used as effectively as possible, to reduce the risk of default on payments.

Green accounting

Aside from using cost data to assess the financial risk of their investments, it’s become more important for funders to place greater emphasis on investing in projects run by companies that set science-based targets (SBTs). Increasingly, they use frameworks created by the Institutional Investors Group for Climate Change (IIGCC) and The Carbon Trust – who work with corporates and governments, to help them align their strategies with climate science and meet the goals of the Paris Agreement – to guide these decisions.

They also use guidelines and frameworks set out by The Carbon Risk Real Estate Monitor (CRREM), a project developed by the Sustainability Consortium. This was designed to help investors assess and manage risk in the real estate sector related to climate change. With the onus on reducing embodied carbon, CRREM’s aim is to rank the performance of a building against science-based targets. To avoid the risk of stranded assets, it makes sense for lenders to use tools that combine both cost and carbon data, to check the sustainability of the projects they’re looking to invest in.

Conclusion

With the help of reliable cost data, funders can make better-informed decisions about where they choose to invest, garner more knowledge and insight into the viability of projects, and reduce both financial and operational risks.

The Building Cost Information Service (BCIS) is the leading provider of cost and carbon data to the UK built environment. Over 4,000 subscribing funders, consultants, clients and contractors use BCIS products to control costs, manage budgets, mitigate risk and improve project performance. Find out more about BCIS CapX here.