Acme Loans regularly extends financing to borrowers for fix and flip projects.
A prospective borrower has approached Acme requesting a loan to fund the development of four medical buildings. Acme really wants to expand the types of loans that it makes, and the prospective borrower would be a great source of new originations. Acme decides that it will extend the requested financing. While Acme has years of experience making fix and flip loans, it has never financed a ground-up construction project. Although Acme’s lending guidelines follow industry best practices for fix and flip loans, they are not in line with those observed by construction lenders, especially in the areas of underwriting, collateral, and insurance.
Underwriting a construction loan requires a lender to engage in a deeper look at the borrower, the property, and the project, than asset-based lending.
1. Get to know the borrower.
Through the underwriting process, the lender should be able to understand whether the borrower is capable of managing the construction project, and if it is not clear that the borrower has the requisite experience, it may be time to pass on making the loan or to take steps to mitigate the potential risk. A lender should know the answer to the following questions about the borrower:
- Has the borrower previously completed a project similar to the current one?
- What is the borrower’s track record on construction projects, including whether the project(s) were completed on budget and in a timely manner, and does the value of the completed project meet or exceed the projected value?
2. Get to know the project.
It is critical that a lender considering a potential construction loan not only know the borrower, but also the project, including the current stage, the other parties involved with the borrower, and the anticipated construction costs. The lender should understand:
- What is the status? Have the plans been approved and permits issued? Has a general contractor hired? Has construction commenced?
- Does the borrower own the real property, plans, permits, utility rights, and other development related assets? If not, who does and why is it not the borrower? All contracts, plans, permits, and any other construction-related documents should be requested from the borrower.
- Is the requested financing and/or proposed budget and draw schedule consistent with the scope of work?
- If it is mid-construction, what is left? Can the project be completed within the budget? Are there mechanic’s liens? Has the quality of work to date been reviewed?
Remember, no borrower or project is perfect, but there are things that a lender can do to mitigate the risks associated with a less than perfect borrower or project.
- Require the borrower to have “skin in the game” by investing his or her own funds in the project, which funds shall be the first used prior to drawing off your loan.
- Limit the timing and number of draws.
- Set progress benchmarks and strictly enforce them.
- Factor soft costs and contingencies into the budget if they are not already included.
- Require additional collateral.
There are two main reasons that a construction lender wants to take a given piece of collateral to secure its loan. First, adequate security will minimize or possibly eliminate losses resulting from a failed project. Second, and just as important, requiring the pledge of the right security will position the lender to step in and ensure that a project is completed upon an event of default.
Examples of collateral aimed at transitioning a project to the lender, include:
- Collateral Assignment of Plans, Permits, and Utility Rights.
- Collateral Assignment of Construction Contracts (especially the general contractor’s agreement).
- Construction Materials.
- Pledge of the ownership interests in the borrower, property owner, and/or developer.
It is important to ensure that the collateral assignments are given by the proper parties. It is not uncommon for ownership of the pledged items to be held by multiple parties, so the borrower may not be the appropriate party to execute the assignment. Therefore, as mentioned above in the discussion of underwriting, copies of all plans, permits, contracts, and the like should be provided to the lender to ensure the proper parties are executing the collateral assignments – architect; contractor; affiliate of borrower; developer; etc.
Construction projects present a unique set of risks that can be reduced by properly insuring the transaction. The additional insurance needs can be categorized as title, liability, and project related.
1. Title Insurance.
With construction projects comes the issue of mechanic’s liens. The best way for a lender to protect itself against mechanic’s liens is through title insurance, specifically requiring the issuance of an ALTA lender’s policy that does not include the western regional exceptions, also referred to as an “extended” Alta policy by some title insurers. There also should not be any mechanic’s lien-related exceptions allowed on the final policy. In addition, in order to ensure priority of the advances made for construction draws, a lender should also obtain the following endorsements to the title policy:
- ALTA 32 – Provides mechanic’s lien coverage for material services paid on or before the date of coverage, which will be extended with the issuance of ALTA 33
- ALTA 33 – Date down endorsement that modifies the date of coverage and increases policy amount
There are also issues presented if the requested loan will be extended after construction has already commenced. Mid-construction loans carry an elevated risk since there is the possibility of mechanic’s liens arising, but not until after closing of the loan, that have lien priority over the lender’s security instrument. The title company will often require an indemnity package from the borrower, lien releases, and/or cessation of construction for sixty days following the recordation of a notice of cessation or completion, as conditions to issuing the ALTA policy without an exception for mechanic’s liens.
2. Liability/Worker’s Compensation.
Due to the increased number of hazards and hazardous activity associated with construction, lenders should require proof of additional liability and worker’s compensation insurance, and identification of lender as an additional insured or mortgagee on the policy. A serious injury to employee of contractor or a subcontractor could derail the entire project from a financial standpoint.
3. Course of Construction/Builder’s Risk Insurance.
Course of construction insurance, also known as builder’s risk, is a form of hazard insurance that covers the structure in various stages of completion, as well as materials and equipment used in construction. The policy, including endorsements, should protect the construction project from property damage due to fire, lightening, hail, explosions, theft, vandalism, and acts of God, among other things. Course of construction insurance can cover the completion value, as well as lost sales, rental income, additional interest on loans, and real estate taxes.
Construction loans have unique challenges that should not be overlooked. Any additional risks associated with making a construction loan can be mitigated by proper underwriting, adequate collateral, and appropriate insurance coverage. The effective incorporation of these principles into a lender’s practices will have a direct correlation to success. In addition to the items outlined herein, a lender also should make sure it adequately documents the transaction; and if a lender lacks expertise to manage construction advances, that it uses a third-party who does, such as a funds control firm.