#32 - Gremlins
How to tell if your project is infested.
In This Issue
Gremlins
Next month I’m presenting to a large Canadian lender about how to identify project risks before they become defaults. Along with some co-presenters, I’ll be presenting a diagnostic framework along with some suggestions for addressing small issues before they turn into big ones.
I figure this is relevant not only to lenders, but also to institutional equity investors and to developers trying to sharpen their own project management practices, so I want to share some of the principles here.
Ultimately, this is all about how to assess a project’s quality. I don’t mean the quality of a project’s design or construction, but rather the quality of the enterprise of building a building. This is a very different thing from the physical building itself.
Hidden Problems
The market is really tough right now, and lots of projects are facing challenges. Here’s a list of the most common problems I see in the market today.
Cost overruns
A weak leasing/sales market
Regulatory and construction delays
Site-specific challenges (e.g. contaminated soil)
Aggressive underwriting
Poor coordination and project management
Poor construction management and procurement
Weak reporting
In addition to the more common problems above, some projects are facing another serious issue: fraud.
Unfortunately, to an outside observer it’s difficult to tell which of these problems are impacting any given project. I call these kinds of hidden problems gremlins. It’s really hard to spot them, but the havoc they cause is obvious to anyone looking.
Every development team has powerful incentives to hide gremlins. It is usually easier to blame external forces for bad outcomes and take credit for favorable ones. Human psychology and financial incentives both work against admitting problems early and improving internal operations. It takes real leadership to identify your own gremlins and deal with them!
Because it can be so difficult to tell what’s really going on, lenders and equity investors often need to look for derivative signals of gremlins. What are some warning signs that a project is veering off course? And what signals tell you if a team is dealing with problems honestly and competently?
Here are some common warning signs that lenders and investors should look out for.
Signals in Reporting
Lots of caveats and qualifications in reports. By the time you’re under construction, your contractor and cost consultant should not be issuing documents with long lists of qualifications and assumptions about cost and schedule.
Irregular reporting and funding requests. These should be coming on a regular cadence, particularly during construction. Take note if these are not following a reliable schedule, or if funding requests are very lumpy.
Lack of detail. Every firm has different standards, but there’s a correlation between detail and quality in my experience. Reporting should include permit logs, change order logs, lots of schedule detail, and so on. And if this isn’t included in standard reports, it should be available at request without any significant delay. If your reported budget is just five or six lines, you are missing lots of important detail.
Late or incomplete financials. Most project agreements require periodic financial statements, often audited. Insist on receiving these, and read them! If you notice anything unusual, consider asking for a general ledger report.
Variance reporting shenanigans. Variances should always be reported against approved budgets and schedules (or ideally, the project’s initial underwriting) and not against what was shown in the previous report.
Signals in Project Execution
Delays. Almost every large project will experience some form of schedule pressure. There’s a big difference between a delay with a tangible root cause and clear recovery plan, versus repeated delay claims with hand-waving and blame-shifting. This becomes a red flag if you are losing time at a 1:1 ratio. For example, if the project schedule slips by three months over three months of reporting, your project is at a standstill and you probably have one or more big problems.
Stale RFIs and submittals. These should be reported every month, and individual items should not stay on the log for many weeks or months.
Manpower seems low. This one is harder to track unless your construction manager/GC reports it directly. I like to show up on-site at the same time every week, take a bunch of photos that I can review later, and also do a manual count of workers.
Change orders. Every project will have change orders. But you want to have total transparency into potential, proposed, pending, and executed change orders. Without very close, regular updating of some kind of tracker, the team may not actually know how much cost exposure their project faces! This is more common than you might think.
Slow buyout progress. This is a big one. Major contracts should be awarded as early as reasonably possible. There are exceptions, but having lots of late contract awards is usually correlated with poor design coordination or eventual cost overruns.
Turnover in key staff. People change jobs all the time, it’s a normal part of business. But you should take note when one or more key people leave a team in the middle of a project. Many distressed developers experience mass resignations once it becomes internally clear there are problems, and external consultants/managers will sometimes quit when a project is very difficult or unpleasant.
Signals of Financial Strain
Burn rates. Review individual budget lines against overall project progress. The architect’s fees shouldn’t be 80% expended before construction documents are begun. Check your interest expense line against the reported schedule to see if there is enough time and budget to finish the project.
Liens. You shouldn’t have vendors putting liens on your property! Sometimes this isn’t the developer’s fault, but it’s worth digging into every time.
New/unreported financing. This is often a default under the loan agreement, but it’s more common than you might think. Consider running a quarterly title report.
What To Do About Gremlins
Once you identify that a project is suffering from gremlins, you need to come up with an action plan. This will vary a lot depending on the problem and the resources available to the project. I can share some general principles here, but your particular situation will probably require a custom solution.
Nonetheless, it is always important to start by getting to ground truth, and figuring out what’s at the root of the problem.
First, it’s important to ask for transparency. Without clear, accurate reporting, it’s impossible to know what’s actually happening with a project. Insist on good reporting practices — showing variances against approved budgets and schedules, and including detailed financial, procurement, and process information. You probably have contractual rights to this information, so exercise those rights.
Second, do a “vibe check”. When you ask for information, is the manager forthcoming and responsive? Or do you need to follow up and push hard for answers? If you run into a lot of resistance, it’s a signal worth noting and it should inform your negotiating posture.
Third, don’t kick the can. All huge problems started out as small problems. If your borrower does not have the capital to bring a loan into balance today, is it likely they will have it when the outstanding debt is twice as large at completion? You generally don’t want to throw a project directly into enforcement and eventually insolvency proceedings, but you do want to come up with a game plan as early as possible — how much time does your borrower have? Will you sign a forbearance agreement? Request additional security? Bring on external managers/consultants to assist with project execution?
Good projects are not projects without problems (those do not exist). The real question is whether a team can identify problems early, report on them honestly, and deal with them before they get out of hand. Easy markets hide weak operators and hard markets expose them. And today’s hard market is shining a spotlight on everyone’s ability to execute.
Reading List
Gödel, Escher, Bach: an Eternal Golden Braid, by Douglas Hofstadter. I first read this book maybe 25 years ago, and it made a big impression on me at the time. I’m returning to it now because of its applicability to artificial intelligence and the rise of large language models. The book is huge and sprawling, but at its core, it is about how inanimate matter gives rise to “self” and consciousness.
Why Canada’s GDP per capita crisis is real, from The Hub. A pretty good deep dive into the issue of Canada’s relatively weak economic performance as measured by per-capita GDP. It goes into the debate around per capita GPD as a measure, whether this is a numerator/denominator problem, what’s driving low growth and productivity, and what Canada might do to improve. As an immigrant to Canada, I think this is one of the most important issues facing the country today.
The Future: Made In Cities, by Kevin Bryan for the Toronto Society. This one’s a video, but you’ll love it. Cities appear to be the places where culture, innovation, and growth occur. But the things that make this happen, agglomeration and institutions, are distinct and separate from the physical form of cities. Professor Bryan tries to tease these things apart in a very captivating way.
That’s A Wrap.
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Thank you for reading, and have a great May.