Commercial Construction Financing and the Contingency Reserve

When underwriting a commercial construction loan request, the wise commercial mortgage underwriter will analyze all four of the major elements of the total construction cost.  The major elements are the land cost, the hard costs, the soft costs, and the contingency reserve.

In any commercial construction process, there are always cost overruns.  The contingency reserve builds in a cushion in the commercial construction budget to cover these cost overruns.

What is the proper formula for computing a contingency reserve?  There is nothing written in stone.  I have seen underwriters use 10% of hard costs, but the formula I find the most logical is 5% of hard and softs costs.

Why not include the land cost in the above formula?  The land cost is usually known in advance and is fixed.  It is unlikely that there will be a cost overrun connected to the purchase of the land itself. 

Now of course the cost of grading, excavating, or cutting the roads may be higher than the commercial property developer has budgeted for, but each of these costs are part of hard costs.

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