The importance of tracking hard and soft costs in real estate development projects
-
Hard costs include material, labor, and land remediation
-
Soft costs include architectural and engineering expenses, professional fees, permits, and financing costs
-
Hard costs are incurred during construction and are typically tangible
-
Most soft costs precede construction and are intangible
-
Some soft costs such as insurance, property maintenance, and security are called post-development costs, and they continue after construction
-
Categorizing hard and soft costs correctly is critical for creating accurate financial statements
Real estate development costs can be broken down into hard and soft costs. Hard costs include all expenses directly related to construction, including materials and labor. And soft costs refer to indirect expenses such as permit costs and architectural fees. Typically, hard costs occur during the construction process, and most soft costs precede development, but others continue after completing the project.
Understanding all the costs associated with your project is essential if you want to attract investors, apply for loans, create accurate budgets, and track where your funds are going. Categorizing your costs correctly is also critical for creating accurate real estate pro formas and other financial documents. This process is always complicated for real estate developers, but to ensure that your budget reflects your actual costs, you need detailed estimates about anticipated hard and soft costs.
First, however, you need to understand hard and soft costs. This post breaks down the most common hard and soft costs associated with most construction projects.
What are hard costs?
Hard costs include all expenses related to the physical development of the project. These “brick-and-mortar” costs include materials, labor, and environmental remediation. As a general rule of thumb, hard costs refer to any materials brought to the worksite and costs of activities that happen on the site.
Material costs
Every real estate development project has a long list of materials. Steel, timber, wood, cement, and bricks used to create a building are hard costs. At the same time, the interior components of the building, such as HVAC systems, drywall, and the external finishing touches such as landscaping rocks and trees are also hard costs.
Labor
Labor is one of the highest costs for most projects, after materials. Labor costs include employees and subcontractors. It also covers costs related to every step of the construction process, from paying an excavator to clear to the land and paying a construction crew to erect the building to paying plumbers and electricians to install pipes and wires.
Environmental remediation
These are expenses related to removing toxins, dealing with groundwater contamination, addressing unused underground storage tanks, or remediating other environmental hazards. Paying someone to handle these tasks should be classified as a hard cost. However, you may also incur soft costs such as paying for inspections or obtaining certifications.
What are soft costs?
Soft costs are often intangible, but they are an essential part of completing a project. These include professional services, regulatory fees, and financing costs. Some people also classify land acquisition as a soft cost, while others categorize it separately as a real estate cost. Every project varies, but typically, soft costs make up about 25-30% of the average budget on a real estate development project with hard costs making up the remainder.
Architectural, engineering, and professional fees
Architects and engineers create the blueprints for your project, and you incur these soft costs long before breaking ground. You also may incur accounting and legal fees as well as project management fees. These costs are not considered hard costs because they do not occur on the construction site and are indirectly related to the actual construction of the development.
Inspection fees and permits
Obtaining building permits and paying for inspections is another soft cost that every real estate development project incurs. You may need to pay for inspections during the due diligence process and again once the project has been completed. There may also be regulatory fees. Similarly, costs related to LEED certification are also soft costs.
Financing costs
Financing costs include interest on bridge loans, appraisal fees, construction lender fees, financing fees, paying mortgage loan brokers, and similar costs related to obtaining and maintaining loans for your project.
Post-development costs
Some soft costs may continue after construction is complete. If the developer holds or sells their project after completion, these costs may continue for varying amounts of time. Post-development costs can include advertising, property management expenses, building operation and maintenance costs, insurance, and security costs.
Knowing the difference between hard and soft costs matters
Developers need to fill out their real estate pro formas as accurately as possible. Understanding the difference between these costs is critical for that process. Hard and soft costs can also affect the revenue recognition process. Incorrectly categorizing these expenses can alter the accuracy of profit and loss statements or other financial reports supplied to lenders or prospective investors.
Knowing the financial ins and outs of your development project is essential to safeguard your bottom line and ensure the project’s success. Lenders, investors, insurers, clients, and anyone else invested in the success of your project wants, needs, and deserves to have a clear picture of what is happening.
If you need help understanding hard and soft costs, you need a professional who has a proven track record of assisting real estate developers with their accounting needs.
Contact Franco Blueprint today. We provide CFO and accounting services to real estate developers and businesses in a wide range of other industries, and we look forward to working with you.