To finance slow payments, the estimated overhead included in subcontractors’ bids is 2.75% and 5.81% for general contractors. This year’s report uncovered that slow payments to subcontractors and general contractors will create $136B in additional costs for the US Construction Industry in 2021.
9 Best Practices for Managing Change Orders as a Real Estate Developer
Death and taxes are not the only inevitabilities. Change orders on a construction project fits into this category as well. Accept it. Plan for it. Live with it. Change orders are going to happen.
Whether you are a development associate, project manager or owner’s representative, properly managing change orders on a construction project is essential to ensuring that the project keeps moving forward and doesn’t exceed the planned budget.
This is in fact what a contingency is for. A contingency is defined as: a future event or circumstance which is possible but cannot be predicted with certainty. When planning the project, you predict uncertainty by including a contingency. The change order is the process of transforming this uncertainty into a certainty.
Therein, this process has nine key steps that should be accounted for when outlining a process for managing change orders on your project:
1. Prevent Changes At Contract Execution
- A change order is a change to a contract. Therein, the best way to avoid changes is to ensure all parts of the project are included in the original contract.
- Many change orders are the result of owner requested changes or unforeseen conditions; however, a fair amount can be attributed to gaps in construction drawings or poor specification of what is included in the contract.
- The better you can include everything you will need in the project during the original contract negotiations, the better things will be. Once a contract is signed, your leverage for negotiation goes down significantly.
2. Plan for Change Orders in the Contract
- When executing a contract with a vendor, outline the process by which change orders will be managed so that each side is clear on the expectations for how these items will be addressed.
- The AIA contracts have standard language on how change orders are to be managed including: notice provisions, documentation requirements, etc. Including similar understanding in your various contracts will better ensure this process goes smoothly.
- At minimum, you should include basic labor rates and how much overhead and profit can be added to change orders so that you are not left fighting these items once the project has started.
3. Plan for Change Orders with Capital Partners
- Your equity partners and lenders are aware that change orders are going to come up on a project. They just want to know you have a plan to manage them properly.
- Talking through what notice and approval requirements they expect during the project is a best practice for the beginning of the project. Some will expect monthly potential change orders (PCO) logs. Others will simply want to know what has been executed.
- When you are kicking off the project and discussing the monthly draw process, include time to discuss change order management and what approvals are going to be expected/required from each party.
4. Document Proactively
- Do not wait for the contractor or engineer to send you a bill or a PCO log. If you know the soils report came back bad or that you had to buy different light fixtures, start tracking those costs and how they impact your budget immediately.
- The project has now started and items are coming up that are not in the contract. Start logging those items immediately and assigning a cost to them.
- The level of specificity can be reduced to an order of magnitude ($1,000, $10,000, or $100,000), but logging these exposures and how they impact your budget will be key to staying ahead of the issue.
5. Resolve Quickly
- Once an issue has been brought to your attention, a quick decision is often critical. Unfortunately, many items only come up when someone goes to start the corresponding work. As such, for them to continue the work they need a decision quickly.
- At this time, it is often difficult to resolve the various components of a change order (who pays for it, how much it costs, and how it impacts the schedule). The main point is to prevent it from impacting the schedule.
- While it is ideal if you can agree on the total cost and who incurs that cost, it is often prudent to have them start on a time and material basis (ideally with an agreed upon labor rate already included in the contract).
6. Request Backup
- When evaluating the costs and impact of a change order, you need the related backup information. If there is a claim of a schedule impact, they should be able to provide a critical path schedule that shows the impact of the additional days or delays in starting the corresponding work.
- For cost impacts, you should receive material estimates (or receipts if the work has been completed) as well as the estimated hours to complete the work (or time sheets if the work has been completed). With this time and material backup, you can gain more confidence in the amount being quoted.
- Sometimes it will be worthwhile to reference a publicly available resource of related costs for similar work like RSMeans. That said, you should have a good understanding of costs of the corresponding vendor and work based off of your existing contract with the vendor.
7. Review Contract
- The change order does not exist in a vacuum. It is a document that references the existing contract with the vendor. Therein, you should review that contract.
- What does the contract say for labor costs? What does it say for the allowable overhead and profit? What does it say for backup requirements?
- The biggest question when reviewing a change order is “is this outside of the contract?” The better you did at step 1, the more likely the answer will be no. Don’t assume that just because the contractor or vendor has submitted a change order that it is in fact a cost you are required to pay.
8. Ensure Sufficient Budget
- After evaluating the costs and the contract, the next step is to understand how this change order impacts the overall project finances. If you did step 2 properly, this should simply be updating the final cost of the change order.
- At this stage, you want to make sure that you have adequate budget in the line item impacted or that you are able to pull from contingency for the associated costs.
- If you do not have budget or contingency, the change order will require additional funding for the project likely from an equity source. The sooner you can plan for that, the less likely it will be to impact the project progression.
9. Coordinate Approvals / Documentation
- After agreeing to costs and confirming the budget, the last step is to finalize execution of the change order. Depending on your internal structure and the size of the change, this may require investment committee, equity partner or lender approval. The more you have discussed this process at the beginning (from Step 3) of the project, the better you will be able to avoid issues.
- Typically, the change order will require the signature of the individual who signed the original contract. Once they have executed the change order, logging that change in your exposures log (from Step 4) will enable you to keep your committed budget and anticipated costs up to date.
Change orders are no picnic. But if you plan for them well, they can be less significantly painful. Getting into a regular cadence of reviewing outstanding costs and closing them out is important. What happens all too often is that people wait until the end of the project to close out the change orders. This is painful as you are looking to complete closeout and retainage release while subcontractors are waiting for payments on change orders they did months ago.
Address change orders from beginning to end in a timely manner. Accepting that they will happen and having a plan to manage them will keep everyone in the project happy (and productive). You cannot avoid them and have them go away so dive in head first and manage them head-on with your vendors. They will appreciate it and it will result in fewer headaches in the long run.