Construction Loan Considerations: Five Best Practices for Lenders

Construction Loan Considerations

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Construction loan projects always carry some risk for lenders: buildings could be left half-finished, a mechanic’s lien could leapfrog yours, or the loan could be used for non-construction purposes. Lenders who take the time to craft and implement a set of best practices that they improve over time can minimize the risk to their finances when lending for large construction projects.

Even sizable projects regularly get financed, though only after lenders have thoroughly considered the associated risks. Lenders can find a project for whatever amount they are comfortable with. Projects run the gamut from smaller rehabs and flips to brand new “ground up” construction – the sky’s the limit. Larger construction loans do not automatically come with higher risks as long as the lender does the necessary prep work and obtains additional security. 

Recognize the Risk Inherent to Construction Loans

Lending money for construction projects carries a meaningful level of risk.  Besides the risk inherent in the construction process, examples include those posed by the location of the property, changes in regulations, fluctuations in the market, and ability to repay or refinance. Lenders should develop an overarching vision and strategy. They should also evaluate each borrower to determine if the project aligns with their risk tolerance.

Central to financing any construction project is determining risks to the completion process. Construction risks include risks that go beyond those specific to the buyer. Lenders must understand building specifications, comprehend local ordinances, and keep up to date with any changes to building codes. These are the “hidden risks” associated with construction loans in addition to traditional risks like unexpected increases in material and labor costs for projects. Lenders can gain confidence in making sound lending decisions through taking a comprehensive view of risks and developing a plan.

1. Insurance

Title Insurance

The first step of the construction loan process is to work with the title company to determine if there are any existing mechanic liens. They should also determine whether an indemnity package is necessary to move forward with the project.  Oftentimes, in order to provide comprehensive construction loan coverage, title companies will require an indemnity package which requires lien waivers and releases. These waivers and releases by the contractors, mechanics, and other parties are important to confirm that mechanics liens are not an issue.

Lenders should take mechanics liens seriously, as they can threaten the lender’s lien position. Lenders should request ALTA 32 (lien priority) and ALTA 33 (disbursement) coverage to protect lien priority against the threat caused by construction projects and draws. The title company should insure continued lien priority protection for the lender throughout the life in the loan. If the title company is not willing to provide this coverage, lenders should change title companies to obtain the coverage. Alternatively, they can consider not making the loan, because these protections are crucial to risk mitigation.

Builder’s Risk Insurance

Loans commonly require liability insurance and hazard insurance, but typically do not cover construction. Lenders new to construction loans may forget to think about builder’s risk insurance, but this would be a mistake. Builder’s risk insurance covers the cost of materials, supplies, or equipment that has not yet been installed in a project but that has been purchased to use in that project. Lenders should require that they be listed mortgagee on a builder’s risk policy before they close the loan.

2. Construction Loan Financing Options

For decades construction lenders have allowed borrowers to finance 100% of final value of the developed property. Nowadays lenders typically cap loans at 75-80% in order to compel a buy-in from borrowers and reduce the risk for the lender. Lenders are moving to minimize risk, causing full financing to lose popularity. To help limit risk, lenders should consider limiting their loan amounts to only a portion of the project or requiring borrowers to bring funds to the project.

3. Consider Requiring Assignments

Construction loans are especially tricky because the lender may end up owning a partially completed property if they foreclose on the loan. Picking up a project midstream can be frustrating at best and near impossible at worst. To protect against this nightmare, many lenders choose to require assignments of contracts, plans, and permits. Some lenders even require an assignment of the bonds related to the project.

Assignments of Contracts as a Precaution

Prior to funding the loan, lenders should thoroughly review all third-party contracts. Lenders may prepare for the possibility of a default by securing assignments of the borrower’s contracts with design professionals or with contractors. They can also require assignment of any and all plans and appropriate permits pertaining to the construction. 

Mind the Bonding Requirements

Performance and payment bonds are necessary for construction loans.  The best performance bonds guarantee the contract will be fulfilled exactly as stated. This ensures development conforms with the nuances of specifications and plans.  Most construction lenders mandate a dual oblige rider for bonds that ultimately transforms the lender into an oblige, ensuring even more influence during negotiations. Other lenders require an assignment of the bonds so that in the event of foreclosure they do not need to obtain new bonds in order to continue construction.

4. Stay Vigilant!

Unlike traditional loans where you lend the money then watch the payments come in, construction loans require more involvement. Lenders need to pay attention at all stages of the loan because funds will be given out in draws after the closing date. For example, lenders should require draw inspections, create transparent and flexible budgets, and create policies that are then followed.

Draw Inspections

Diving deeply into borrower analysis before the lender decides to lend to a borrower is important, but this is not where the lender’s due diligence should end. With construction loans, the lender provides funds to the borrower a little at a time in draws. These draws should be accompanied by draw inspections where the lender or preferably a third party. Leaning on an engineer or independent architect to conduct, or at least monitor, construction sites inspections is an absolute-must. This architect or engineer should provide an unbiased review of the site to identify all potential risks. This way, the lenders are aware of any problems early and can respond accordingly.

Transparent and Flexible Project Budgets

Private lenders that attempt to keep track of all the information related to a potential construction loan with the use of a single spreadsheet are bound to make a mistake.  Lenders should not be afraid to upgrade from the cumbersome spreadsheets to facilitate management. Instead of trying to manage spreadsheets, opt for software specifically made for construction loan management.

Create Policies and Follow Them

Lenders should create policies and procedures for dealing with various aspects of construction loans such as a procedure for providing draws. After setting the policy, lenders should strive to follow it religiously. They should then document any deviation from the policy in case of an audit, and should examine them periodically to make sure that the exceptions are fair, reasonable, and not discriminatory.

5. Proper Documentation

Proper documentation of the loan and terms is one of the very best ways to mitigate risk. Lenders should be sure to carefully document exactly how the construction reserve will function including but not limited to the uses of the construction reserve, the administration of the construction reserve, and the conditions precedent to disbursements. The loan documents should also have an extensive set of construction defaults which will provide protections for the lenders.

The inherent risk of lending on construction loans is lessened by using lender-friendly loan documents. These should carefully outline exactly how the construction loan will work and provide robust protection.  Lenders should consider crafting a set of provisions before deciding to lend on construction loans.

Construction loans are inherently risky, but the rewards can be great. Lenders should require strong title and builder’s risk policies, require borrower investment to limit their financial obligations, obtain assignments to construction-related agreements, pay attention during the life of the loan to how and when the funds are used, and focus on proper documentation of terms.

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