The Construction Process: Part Two

Paying the bills!

The walls are going up. Things are happening. And eventually, folks need to get paid, right?

Right.

Equity and Loans

You'll remember we raised equity from investors and got a sizable loan from a bank. Equity is the amount of money invested by the project's owners or investors, not borrowed from the bank. Combined together, that’s the money we're going to spend to build the project.

Loan Draws

But how does that work?

You submit what's called a loan draw to the bank. A loan draw is a request for funds from the bank to pay for construction expenses, submitted periodically as the project progresses. One thing to note before we get into the loan draws is that when a bank loans you money and you raise equity, the bank requires that you spend the equity first.

Why? Because that’s your skin in the game.

Typically, for the first three or four months of a project, the contractors do the work and send you invoices that get paid with equity. Once the equity has been drawn, once you've spent all of your equity, then, and only then, will the lender start sending you loan proceeds to pay for things.

Pay Applications

How does it work?

Your general contractor has subcontractors working under him or her. The subcontractors do various amounts of work and send invoices to the contractor. Typically, once a month, the contractor compiles all of those invoices (along with their own invoice for whatever work they've done) and submits them to you in what's called a pay application. A pay application is a document submitted by the contractor to the owner and architect, listing the work completed and the amount of payment requested.

The architect typically reviews it first and asks any questions. Remember, the architect does site walks every week, so they know where they should be in the process. Once the architect reviews and signs it, it goes to the owner.

Verification and Payment

The owner confirms the work again, double-checking that the work was done because you NEVER, EVER prepay a contractor for anything.

You are only paying for work that has been completed and verified.

Never, ever prepay a contractor for anything.

Okay, I think that's clear.

Sorry.

Didn’t mean to get all shouty there.

Loan Draw Forms and Budget

So, the owner gets the signed pay application from the architect, who has reviewed it and signed off. When you close your loan (you'll recall we had a budget, right?), each budget has a category. The bank will send you a loan draw form where it will show the budget. The budget will be broken down, typically into 15 to 20 categories on your pro forma. The bank simplifies this a little bit and lumps things together into eight to ten categories on your loan draw sheet.

You'll take all the costs that you're going to pay people back for (work that's been completed) and put it into one of the line items on there. It's basically like balancing a checkbook. You'll take the amount, deduct it from the total, and say, "This is how much we need to get paid." And then there's a new total at the end. The budget doesn't change typically, but each line item goes down as you pay it down. Then, once the owner has all this, they will prepare what's called a loan draw.

Including Soft Costs

But wait.

You’ll also include any soft costs (expenses not directly related to the physical construction of the building, such as architectural fees, marketing expenses, and furniture). Remember, soft costs are still part of this, too. We're not just paying the contractor. Maybe we've started marketing, maybe we've started working with a branding company. Or maybe we still owe the architects for their construction administration that month. So there are also some soft costs.

You'll compile everything together, include all the supporting documentation, and then send the lien waivers (a document stating they have been paid and therefore waive any future lien rights to the property for the amount paid), a contractor pay application, and all supporting documentation to the title company.

Title Company and Fund Distribution

The loan draw goes to the title company, they review it, and if there are any questions, they'll get back to you. Once they've reviewed it, they tell the bank that this loan draw has been approved. Then, the bank will go ahead and wire funds back to the title company. You're not actually touching the money. It goes back to the title company, and then when the title company gets the money from the bank, they issue checks to all the people who were listed on the sheet.

Then, checks are mailed.

Potential Issues and Change Orders

Do issues happen?

Yup. Checks sometimes go out to the wrong place.

That is why you need to be all over this process, checking in regularly with all of the team.

Apart from checks ending up at the wrong address, the most common potential headache in this process is what's called a change order. It starts with a potential change order (PCO). A PCO is a proposed change to the construction contract that may increase or decrease the project cost or timeline, subject to approval. That’s the fancy developer definition. The straight-talk definition is that you changed your mind, and that change is about to cost you money :-)

For example, when we were building Akin, during one of my weekly walks, I discovered that the wrong elevator flooring had been installed. We went back, had a meeting, and figured out that somebody had ordered the wrong material - a material that I had later reconsidered.

But...

This change was never documented, which meant we had to pay $4,000 for new elevator flooring.

Ouch.

That's where the contingency line item comes in. Remember, the contingency line item is a budget category set aside to cover unexpected costs or changes in a project (or when Sean forgets to tell his team that he hates the elevator flooring in the initial plans).

You would also pay for that out of the contingency line item. Once you figure out who's paying for it, it becomes a prime contract change order (PCCO). A PCCO, or prime contract change order, is an approved change to the construction contract that officially alters the project's budget or timeline.

Managing the payment process in construction is all about staying organized and on top of things. By understanding how the money flows—from equity and loan draws to pay applications and change orders—you keep your project running smoothly. Always make sure the work is done before paying for it, and keep an eye on your budget, especially when unexpected costs come up. With a little diligence and good communication, you'll navigate the financial side of construction like a pro and bring your project to a successful, on-budget finish.