When you start a real estate development project, your initial budget is one of the most important aspects. Properly calculating this means you must understand the difference between hard costs vs. soft costs.
These expenses are the feet your project will stand on, and—to use a classical analogy—you don’t want them to be made of clay.
Your hard costs and soft costs will impact both financing approval and the overall success of any real estate development project.
Let’s look at hard costs vs. soft costs and their influence on real estate development financing.
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What are the hard costs?
Hard costs in real estate development refer to the tangible, physical construction expenses involved in a project.
These costs are directly associated with the building process and include materials, labor, and other expenses related to the direct physical construction of the structure.
Soft costs, in contrast, are the indirect costs associated with a real estate project.
These include expenses like architectural design, legal fees, permits, insurance, and interest payments during construction.
Unlike hard costs, soft costs are not directly tied to the physical construction but are essential for project completion.
The primary difference lies in their direct association with the construction process.
Hard costs are directly linked to the physical creation of the building, while soft costs are ancillary yet essential expenses that support the overall project.
Understanding and accurately projecting hard costs is crucial for lenders and developers alike.
Often described as “brick and mortar” expenses, these hard costs are fundamental to the physical manifestation of a development project.
These costs generally encompass:
- Construction materials: This covers the expenses for essential building materials such as steel, concrete, wood, and other key structural elements.
- Labor costs: This pertains to the expenses incurred for construction labor, which includes wages, employee benefits, and payroll taxes.
- Site work expenses: These costs are related to preparing the site for construction, which involves excavation, setting up utilities, and other preliminary site work.
- Equipment costs: The costs involved in either purchasing or renting the necessary construction equipment and machinery.
Lenders inspect hard costs closely, as they form the lion’s share (the majority) of the construction expenses.
Accurate estimates and efficient use of resources in hard costs are seen as indicators of a project’s feasibility and the developer’s competency.
A well-planned hard cost budget is essential for project feasibility.
Overestimating these costs can lead to unnecessary financial burden while underestimating them can result in funding shortfalls.
Soft costs, though less tangible, are equally critical in project development.
Soft costs in real estate development typically encompass a variety of non-physical expenses essential to the project, such as:
- Architectural and engineering fees: These are the costs incurred for the design and architectural planning of the development.
- Legal fees: The expenses for legal counsel and services that are necessary throughout the development process.
- Environmental research: The costs involved in conducting environmental studies and assessments to understand the project’s environmental impact.
- Marketing: Various expenditures related to the promotion of the property, including activities like advertising and branding.
- Insurance: The costs for securing different types of insurance coverage during the various phases of development.
- Permits: Fees associated with acquiring the required permits needed for construction and overall development.
- Taxes: Various tax-related expenses that apply to the development project.
From a lender’s point of view, soft costs are evaluated for their reasonableness and necessity.
Lenders are particularly attentive to how these costs are managed and their proportion concerning the total project cost.
Effective management of soft costs involves diligent planning and monitoring.
Developers must ensure that these costs are kept within reasonable limits and are justified in the context of the overall project.
Overinflated soft costs can signal mismanagement or unrealistic project planning, negatively impacting a lender’s assessment and ultimately passing on funding the loan.
Striking the right balance between hard costs and soft costs is vital in real estate development.
A well-balanced budget reflects a realistic and feasible project.
Effective cost optimization strategies involve:
- Rigorous market research
- Competitive bidding for contracts
- Prudent selection of services
It’s crucial to maintain a balance where neither hard nor soft costs disproportionately affect the project’s financial structure.
Leveraging technology for efficient project management can also play a pivotal role in cost optimization.
A common mistake in project budgeting is underestimating soft costs, which can lead to significant financial strain later in the project.
Underestimating soft costs can ultimately lead to a project being delayed or not getting completed due to improper budgeting.
Developers should ensure that all potential costs, including unexpected ones, are accounted for in the budget.
In the context of real estate development, traditional financing avenues often fall short, especially for unique or rapid development projects.
When conventional lenders are far too slow or inexperienced about how a development project has to proceed, they often turn to hard money lenders to bridge the gap.
They focus on the asset’s value, as it is currently or the future value of the project, rather than the borrower’s credit history, offering a practical solution for diverse development needs.
Hard money loans are customizable—able to suit the specific requirements of a development project.
This flexibility allows developers to cover both hard and soft costs effectively, ensuring the continuous flow of funds throughout the project lifecycle.
Marquee Funding Group specializes in providing hard money loans tailored to the unique demands of real estate development.
With an understanding of the complexities involved in real estate projects, Marquee Funding Group offers customizable, flexible financing solutions that align with your specific needs as a developer.
Submit your loan scenario and discover how we can help you achieve your real estate development goals.