The Stress of Busted Construction Projects

Busted construction projects can be extremely stressful for a lender.

Construction projects are inherently risky and don’t always go as planned. A lender is literally providing funds to a borrower who will “lego” together the lender’s collateral.  This risk can be heightened by a host of factors ranging from a borrower with insufficient development experience to complete the project, an insufficiently capitalized general contractor who misappropriates project funds to pay operating expenses or subsidize another project, to supply chain issues causing delays and increased costs.  All of these factors can derail things leaving lenders with busted construction projects and some major decisions on how to move forward.    

Evaluate the Project

When evaluating what steps to take after a busted construction project, a lender should first determine the root cause of the failure.  If the borrower was at fault, the lender should consider strategies that remove the borrower from the process going forward.  If the general contractor was at fault, the lender should consider strategies to replace the general contractor. 

The lender should also determine if cost overruns derailed the project’s completion.  To this end, the lender should determine if the cost overruns were beyond the borrower’s or general contractor’s control or if they were due to inadequate budgeting by the borrower or contractor.  At this point, the lender must come up with a viable exit strategy for repayment of the loan. 

Exit Strategies for Busted Construction Projects

The first and most obvious exit strategy is for the lender to declare a default and proceed with a trustee’s sale or foreclosure sale.  If a lender chooses to take this route, the lender will likely have to sell the property at a deep discount.  This is due to any potential buyer having to bear the costs of completing busted construction projects and potentially assuming liability for any existing construction defects.  If buyers discount the property deed enough, the lender may not be able to sell the property for an amount sufficient to repay the loan in full, leaving the lender with a deficiency and the lender taking a loss on the loan.

Another exit strategy involves the lender undertaking the role of developer and completing the project.  Even though this strategy could expose the lender to liability for construction defects, the draw of having a completed project to sell is too strong for some lenders to resist.  Most lenders understand that a completed project has much greater value and is more marketable than an incomplete project. 

Suppose the lender decides to complete the project. In that case, it should immediately request an updated title commitment to search the real property records for mechanic’s liens and other encumbrances on the property.  This will give the lender a clear picture of the amounts owed to various parties who have completed work on the construction project but have not yet been paid. Updated title work can also give the lender insight into the borrower’s financial deterioration if monetary judgments have been recorded against the property. 

Conduct a Detailed Analysis

In addition, lenders should undertake detailed analyses of the project costs incurred to date and compare them to an updated project budget to determine exactly how much it will cost to complete busted construction projects. If the construction project is nearly completed, and the remaining costs are not greater than any remaining funds in the construction holdback account or the remaining costs are not too substantial in comparison to the projected value of the completed project, the lender may decide to work with the borrower and extend the loan and provide additional funds or release any remaining portion of the construction holdback to complete the project.

On the other hand, if the project is not substantially completed and the remaining project costs exceed any available construction holdback or would swallow up any projected equity, the lender may decide it is time to cut its losses completely and sell at a discount rather than pour additional funds into the project.  To this end, a lender will want to engage the architect, if any, who prepared the plans and specifications for the project to determine if the current construction has followed the plans or if there have been substantial deviations from the plans. 

Additional Considerations

Other factors may weigh on a lender’s decision to complete busted construction projects. The first is the lender’s experience in completing broken projects.  A lender with substantial experience acting as a developer is more likely to take on the challenges of completing an unfinished construction project.  A lender who has little or no such experience may decide there is no hope of successfully completing the project and simply decide to sell the project at a trustee’s or foreclosure sale.

Lenders must consider the complexity of all busted construction projects.  Is the project a single-family fix-and-flip or a thirty-story mixed-use condo and retail development?   The more complicated the project, the less likely a lender will want to assume the obligations and liabilities for completing the project.

Another important factor that could drive a lender to complete a project is the status of the project’s building permits and other entitlements.  If these are about to expire, a lender may try to complete the project before the expiration date.  An entitled project will have a far greater value than an unentitled project.  However, if the project’s entitlements do not expire for a long period of time, the lender may even decide to sell the project due to a lack of urgency. 

They must also determine whether work is continuing at the work site or if work has been discontinued because the contractor or subcontractors have not been paid.  If the relationship with the contractors and subcontractors can be salvaged, a lender has a strong incentive to have them continue to the completion of the project.  If this is not the case, the lender may face an uphill batter getting the contractors and subcontractors to return to the job site.  Before having the current general contractor or subcontractors continue working on the project, the lender will want to obtain lien waivers. 

Lien waivers can be conditional or unconditional.  They are written agreements executed by a contractor in favor of the lender that waives the contractor’s right to assert a lien against the property or materials delivered to the property.  The lien waiver establishes that the contractor has been paid in full for work completed or materials delivered to the property as of a specific date.   An unconditional lien waiver discharges all of the contractor’s rights through a specific date with no stipulations or reservations.   A conditional lien waiver discharges all of the contractor’s rights through a specific date, but only if the contractor was actually paid for the work.  If it turns out the contractor was not paid, the waiver is ineffective.  

Other types of lien waivers include an unconditional waiver and release upon final payment and a conditional waiver and release upon final payment.   The first discharges all of the contractor’s claims upon receipt of payment, while the latter discharges the claim upon final payment with certain provisions.  A lender should carefully scrutinize the types of lien waivers it receives to be absolutely certain all contractors have been paid and all of their claims have been released.  If a title company has been engaged to provide updated title insurance, the lien waivers should be delivered to the title company which will need to approve them.     

Conclusion

Overall, busted construction projects do not have to be catastrophic events for a lender, whether the lender is the original construction lender or a new lender providing financing to complete a busted project.  In either situation, the lender will have to carefully evaluate the project and formulate an exit strategy that works best for the lender under the circumstances.

Have questions about your construction loans? Contact Geraci Law Firm for a consultation today.