Cost Overruns and Development Finance: How to Protect Your Facility

Cost overruns are one of the most common triggers for development finance defaults in the UK. When build costs exceed the approved budget, the consequences ripple through the entire facility structure. The contingency budget is consumed first, but once that is exhausted, the developer must inject additional equity or find supplementary finance to complete the project. If neither is available, the development stalls — and a stalled development is every lender's worst nightmare, because the security (a partially completed building) is worth significantly less than either the land or the completed project.

The mechanics of how cost overruns affect a development finance facility are straightforward but severe. Most facilities are structured with a fixed build cost budget that has been verified by a quantity surveyor and agreed by the lender. The facility amount is calculated based on this budget — typically seventy to seventy-five percent of total costs. When actual costs exceed the budget, the borrower must fund the difference from their own resources. On a scheme with a £1,800,000 build budget and a ten percent overrun, the developer must find an additional £180,000 that was not in the original plan.

Furthermore, cost overruns can trigger loan-to-cost covenant breaches. If the facility agreement caps the loan at seventy-five percent of total project costs, and total costs increase because of overruns, the borrower may breach this covenant even though they have not drawn any additional funds. The lender may then require the borrower to inject additional equity to restore the covenant ratio, placing further financial pressure on the developer. Understanding these dynamics is critical for anyone managing a development finance facility.

The most frequent cause of cost overruns in our experience is inadequate initial budgeting. Developers — particularly those early in their careers — often prepare build budgets based on the most optimistic assumptions: lowest tender prices, no allowance for variations, and minimal contingency. When the reality of construction hits — material price increases, unforeseen ground conditions, design changes required by building control — the budget is overwhelmed. We always advise developers to base their budgets on the median tender price rather than the lowest, and to include genuine contingency of seven to ten percent for standard schemes and up to fifteen percent for complex projects.

Ground conditions are a persistent source of cost overruns, particularly in parts of the South East where clay soils, high water tables, and contaminated land are common. A site investigation that reveals unexpected ground conditions after construction has started can add £50,000 to £200,000 to foundation costs alone. Developers working in Kent, Essex, and Greater London should budget for comprehensive ground investigations before purchasing a site, even though the cost of £5,000 to £15,000 may seem significant at the feasibility stage.

Material price volatility is another major factor, particularly since 2022 when supply chain disruptions caused dramatic increases in the cost of steel, timber, concrete, and insulation products. While prices have stabilised somewhat, they remain significantly above pre-pandemic levels and are subject to fluctuations driven by global supply and demand. Fixed-price building contracts provide some protection, but many contractors include price escalation clauses that allow them to pass on material cost increases above a specified threshold.

Design changes during construction — whether initiated by the developer, required by building control, or necessitated by site conditions — are a further source of overruns. Every variation requires the architect to issue revised drawings, the quantity surveyor to price the change, and the contractor to adjust their programme and method. The direct cost of the variation is often compounded by delay costs and disruption claims from the contractor. The best way to minimise design changes is to invest in thorough pre-construction design development and to obtain building control pre-application advice before starting on site.

Early identification of cost overruns depends on rigorous financial monitoring throughout the construction phase. The developer should receive monthly cost reports from their quantity surveyor that compare actual expenditure against the approved budget, project the anticipated final cost, and highlight any variances. These reports should be shared with the lender or broker as part of the regular project reporting that we recommend in our guide on avoiding default on development finance.

The key metric to monitor is the anticipated final cost — not just the expenditure to date. A project can appear to be on budget at the halfway point because the most expensive elements have not yet been completed. The quantity surveyor's role is to look ahead and project whether the remaining budget is sufficient to complete the works. If the projected final cost exceeds the approved budget, the overrun should be reported immediately, even if the current expenditure is within budget.

When reporting a cost overrun to your lender, provide a detailed breakdown that shows: the original approved budget by trade or work package, the current anticipated final cost by the same breakdown, the variance for each element, and a clear explanation of the cause of each variance. Support the report with evidence — contractor correspondence, variation orders, ground investigation reports, or whatever documentation explains the cost increase. A lender who receives a well-documented cost report is far more likely to work constructively with the borrower than one who discovers the overrun through the monitoring surveyor's report.

In our experience, the total quantum of the overrun matters less to lenders than the developer's awareness of and response to the issue. A developer who identifies a £150,000 overrun, explains the cause, and presents a funded plan to cover the additional cost will typically retain the lender's confidence. A developer who is unaware of a £50,000 overrun that the monitoring surveyor discovers will cause far more concern, because it suggests the project is not being properly managed.

The first strategy is value engineering — reviewing the specification and design to identify cost savings that do not materially affect the quality or value of the completed development. Common value engineering measures include substituting specified materials with cost-effective alternatives (for example, engineered timber flooring instead of solid hardwood), simplifying the landscaping specification, or revising the kitchen and bathroom specifications. On a typical residential development, value engineering can recover three to eight percent of build costs, which may be sufficient to absorb a moderate overrun.

The second strategy is to negotiate with your contractor. If the overrun is partly attributable to contractor inefficiency or variations that the contractor has priced aggressively, there may be scope to negotiate reduced rates or a revised lump sum. This approach requires a good relationship with the contractor and a willingness to compromise — for example, accepting a slightly later completion date in exchange for reduced variation costs. The developer's quantity surveyor should lead these negotiations with detailed cost analysis to support the developer's position.

The third strategy is to seek additional finance. If the overrun cannot be absorbed through value engineering or contractor negotiations, the developer may need to inject additional equity or arrange supplementary finance. Mezzanine finance can be used to bridge the gap between the senior facility and the total project cost, although arranging mezzanine finance mid-construction is more complex and expensive than at the outset. Alternatively, a topped-up facility from the existing lender or a replacement lender may be available if the development still demonstrates adequate profitability.

The fourth strategy is to re-evaluate the exit strategy. If cost overruns have eroded the project's profitability, it may be necessary to adjust selling prices upward (if the market supports it), consider retaining some units as rental stock rather than selling (which may allow you to refinance onto a longer-term product), or accelerate the sales programme to generate early receipts. The appropriate strategy depends on the specific circumstances of the project and the local market conditions. Contact our deal room for tailored advice on managing cost overruns on your specific facility.

When a cost overrun is identified, the developer must decide how to approach the lender. The starting point is to understand the lender's perspective. The lender's primary concern is whether the facility will be repaid — which depends on the development being completed to a standard and specification that achieves the projected GDV, within a timeframe that allows repayment before or at maturity. If the cost overrun does not threaten the project's viability and the developer can fund the additional costs, the lender may require nothing more than an updated development appraisal and confirmation that additional equity is available.

However, if the cost overrun requires changes to the facility — such as an increase in the facility amount, an extension of the term, or a waiver of a financial covenant — the negotiation becomes more complex. The lender will want to understand why the overrun occurred, whether further overruns are likely, and what assurances the developer can provide that the project will still be completed successfully. Be prepared to provide updated QS reports, contractor correspondence, a revised development appraisal, and evidence of available equity or supplementary funding.

In our experience, lenders are most receptive to facility amendments where the developer has identified the problem early, has a credible plan to resolve it, and is contributing additional equity. A request for a £200,000 facility increase supported by evidence that the developer is injecting £100,000 of additional equity demonstrates shared commitment and is much more likely to be approved than a request for the lender to absorb the entire additional cost. The negotiation process typically takes two to four weeks, during which time the developer should continue progressing the build to maintain momentum and demonstrate commitment.

The most effective protection against cost overruns is a well-structured building contract. A fixed-price lump sum contract (such as JCT Design and Build 2024) transfers the majority of construction cost risk to the contractor, subject to variations instructed by the employer and certain defined circumstances such as unforeseeable ground conditions. While no contract eliminates cost risk entirely, a lump sum contract provides a ceiling on the base build cost that the developer can rely on for budgeting purposes.

Performance bonds and parent company guarantees provide additional protection. A performance bond — typically ten percent of the contract value, costing the developer £3,000 to £8,000 — provides a financial guarantee that the contractor will complete the works. If the contractor defaults, the bond pays out to cover the additional costs of appointing an alternative contractor. A parent company guarantee, where available, provides a direct claim against the contractor's parent company if the contracting entity fails to perform.

Developers should also consider professional indemnity insurance for their design team. If cost overruns are caused by design errors — for example, an architect's failure to identify a structural issue that requires expensive remedial works — the design team's professional indemnity insurance may cover the additional costs. Ensure your design team carries adequate PI cover (typically a minimum of £1,000,000 per claim for residential developments) and that the cover is on an each and every claim basis rather than aggregate.

Finally, ensure your development appraisal includes a realistic contingency that is genuinely uncommitted. We have seen too many appraisals where the contingency is nominally five percent but has already been mentally allocated to known cost items that the developer has excluded from the base budget. A genuine contingency is money that the developer expects not to spend — and is available to absorb the unexpected costs that inevitably arise in construction. If you are planning a new development, our guide to how development finance works covers budgeting and appraisal preparation in detail.

To illustrate these principles, consider a real scenario we helped manage. A developer in Surrey was building a scheme of eight houses with a GDV of £5,600,000 and a total project cost of £3,800,000. The development finance facility was £2,700,000, and the developer had contributed £1,100,000 of equity. The build budget was £2,200,000 with a £110,000 contingency (five percent).

At month eight of an eighteen-month build programme, the quantity surveyor identified that costs were tracking twelve percent above budget — an overrun of £264,000. The causes were a combination of ground conditions requiring additional piling (£95,000), material price increases on timber frame and insulation (£82,000), and variations required by building control to meet updated thermal efficiency standards (£87,000). The contingency was already largely consumed by minor variations earlier in the build.

The developer approached us immediately. We prepared a comprehensive package for the lender showing the cause and quantum of the overrun, a revised development appraisal demonstrating that the project remained viable with a revised profit of fifteen percent on GDV (down from the original twenty-two percent), and evidence that the developer could inject £130,000 of additional equity. We also presented an application for a £134,000 facility increase. The lender approved both the additional equity injection and the facility increase within three weeks, and the development completed on a revised programme without further issues. The key factors in this positive outcome were early identification, transparent communication, and the developer's willingness to share the additional cost burden with the lender.