Soft costs are the intangible cost items such as the professional fees, municipality cost, management fees, sales cost, or taxes in a real estate development project. It may also be helpful to start from what soft cost is NOT. Soft cost is not the land cost, construction cost, or financing cost. These cost items are significant part of a real estate development projects, and so it deserves to be understood and dissected carefully. Any real estate ground-up construction projects has the following soft cost items. Before moving on, the list of items in this article is not a complete list and is meant to illustrate the idea. Each project might have a slightly different requirements which means a different list of items for each soft cost item. Now let's see some examples.
Soft Cost Headings
- Professional Fees
- Municipality Fees
- Land Acquisition (property taxes, fees, and commissions)
- Sales Cost
- Sales Taxes
- Management Fees
Lender's Commitment Letter
Usually, lenders do not include the financing costs as soft costs. A lender's commitment letter typically break-down the costs as follows:
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Land cost$5,000,000
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Acquisition Cost$5,000,000
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Hard-Cost (Construction Cost)$6,000,000
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Soft-Cost$1,000,000
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Interest Reserve Fund$500,000
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Financing Application Fee$50,000
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Total Expenses$12,800,000
The soft cost items are different from a project to project, depending on the local laws and financing requirements. For example, while in commercial projects, phase II environmental study is required to obtain financing for most lenders in most jurisdictions, the residential projects in another jurisdiction might not have that cost item (unless situated in a particular area) as part of their financing requirements. Let’s look at some of the soft costs:
Professional Fees
Professional fees are the fees paid to engineers, architects, and other certified professional consultants in return for plans, drawings, reports, and inspections. A typical professional consultant is responsible to design an aspect of the building to comply with the relevant laws and regulations, typically called building code, plumbing code, electrical code, etc. In most jurisdictions, they are also responsible to make site visits during the time the work is taking place to make sure that the work complies and conforms to the drawings and general intent of the design. Note that most consultants would have it in their contract that they are not responsible for the workmanship of the contractors and that their inspection is limited in scope to what is visible at the time of inspection. In some situations, however, they require test results (such as test result for the ordered concrete). Builders and developers rely on the professionals as the project unfolds and unforesean difficulties, missing details, or design changes call for their direction and approval to continue work.
The list of professionals is different usually based on the municipality and building code requirements. Most commercial projects require a full team of professionals. Here is a typical list:
- Land Surveyor
- Geotechnical/soil engineer
- Architect
- Structural engineer
- Mechanical Engineer
- Electrical Engineer
- Interior Designer
- Civil Engineer
- Landscape architect
- Environmental Consultant
- Building Code Consultant
- Construction Safety Consultant
- Traffic Management Consultant
- Green building/LEED Consultant
- Project Accounting
- Legal
- Insurance
Municipal Fees
Municipalities are responsible to ensure that any change to a property's use meets the bylaw requirements. For that, municipalities charge fees for reviewing plans, issuing development and construction permits, conducting inspections, and issuing the final occupancy. In addition, some municipalities want a piece of the profit pie from any change made to the use or density of the parcels. For example, in a mixed-use residential-commercial project, if the developer applies to change the use or increase the density of the property, this automatically triggers the municipality to require additional fees to upgrade the infrastructure to and from the building, fees to improve the immediate neighbourhood, create amenities, upgrade social programs in the local library or recreation center, add street trees, etc. Each municipality would break-down their fees differently and a prudent real estate developer will check with the municipality to find out what cost items they would require for their proposed development. Also, note that each cost item has a distinct cost and payment schedule. Here is a simple example of the municipality fees:
- Application Fee
- Permit Fee
- Inspection Fee
- Service (water, sewage, etc.) Connection Fee
- Development Levies
- Infrastructure Levy
- Community Improvement Levy
Note that the development levies imposed by municipalities could be more than two levies, depending on the local government act or any other law, but the two-tier structure is the more dominant cost break-down. You can think of it as hard and soft levy, one to upgrade physical infrustructure and the other to improve qualify of life for the community. Municipalities can estimate and forecast the cost to improve the infrastructure, as it is again more of a hard cost, but the community improvement is often more obscure and depends on the type of amenity the project offers as a compliment to what the community already has, the needs of a community, and the political agenda of the local council. For instance, if a multi-family project offers daycare space and a recreational space to its occupants, the cost of creating those amenities for the community is shifted to the project, which could bring the community improvement levy lower for the project compared to the levy for a project which does not offer such amenities. A prudent real estate developer would check these costs with the municipality as part of their due diligence and prior to purchasing the property as these costs could change the purchase price. In some jurisdiction, the municipality might have a specific price for additional density, so the development levies could be easily be estimated using the unit price. For instance, a municipality might have a bylaw in which additional floor area above and beyond what is permitted is sold at $100/square foot.
Acquisition Cost
Depending on where the real estate project is located, the acquisition cost can change drastically. For instance, a state or province might have a property purchase tax for any real estate transaction. Different governments have different tax rates. The real estate agent typically charges based on the purchase price of the property, and this depends on how you negotiate with your real estate agent and what others are charging in your market. To acquire a property, legal fees, accounting fees, feasibility study fees, etc. are also essential cost components. Again, different lawyers and accountants charge differently for different types of projects, which could be based on the type of land acquisition contract and negotiation, market rates for the legal and accounting services in the area, etc.
- Property Purchase Tax
- Real Estate Commission
- Legal Fees
- Accounting Fees
- Feasibility Study Fees
Sales Cost
The sales costs include marketing consultant cost, printing and web advertising, and sales commission. In certain projects, such as single family dwellings, these costs are all rolled into one real estate commission. But, for a larger commercial project, the sales process is divided between a marketing department and sales department, each of which having a separate cost schedule. If you are building a rental project, the sales commission (sometimes referred to as the disposal fees) is typically a percentage of the annual rental income while the sales cost of a strata project is a percentage of the revenue. Like any other sectors, the economy of scale applies which means you would pay less per every square foot in a larger project than a smaller project.
- Marketing Cost
- Printing Cost
- Advertising Cost
- Real Estate Commission (disposal fees)
Management Fees
To build a building, you need a team of managers to manage all the costs, assemble the team of consultants, apply to municipality, engage the community, find the construction crew, do the accounting on daily basis, etc. The manager is responsible to make sure the project is financially successful while keeping the municipality and the community equally happy. This is a challenging task that requires a lot of hard and soft skills. It takes a lot of time, energy, creativity, and cost to achieve this. If a manager is not able to do its job well, the project can fail to get the permits or financially fail.
The management is typically consisting of the development management phase, sales management phase, and the construction management phase. There are different cost charges for each phase, and it is usually based on how much time and resources each phase needs, the size and type of the project, sensitivity of the community and the municipality, construction process, etc. The management fee is typically a percentage of the cost for each phase, e.g. % of construction cost for the construction management, % of revenue for the sales management, and % of development cost for development management fee.
Sales Taxes
In a rental project, depending on the local laws, the taxes may be payable once the project is rented. This could happen prior to the sale of the project, which means that the real estate developer needs to pay a substantial amount of taxes before the sales event. This should be accounted for in the cashflow analysis and the feasibility study. In strata projects, the taxes are paid either by the buyer or at the sales event which means that no additional money should be set aside.
Conclusion
Soft-cost items can be the tricky part of a development project specially for a new land developer or for a developer who enters a new market. Not all cost items are known ahead of time, and the law could also change which could affect the requirements and the cost to satisfy those requirements. A prudent developer should do their due diligence to find out what are the soft cost items for their project and how much they could cost prior to making an offer on a piece of property. One thing is for sure, with the multiple stakeholders and many changing laws and regulations affecting the real estate development, gone are the days you could say $1M for land $1M for the building, $2.2M for sales, so we are making $200k on this. There is clearly a need for a more comprehensive detailed approach to identify cost items and price each cost item to avoid the pain at the end of the project when unforeseen cost items or cost amounts derail the project to unprofitability after putting years of your life. To quickly and efficiently run a proforma and manage the risk, we recommend that you subscribe