Real Estate Pro Forma
Banks assume the risk associated with the developer’s ability to complete a project on time and within the proposed budget. A credible pro forma, which is merely the projected income of the business, is key to assisting the lender in determining if a project is feasible, based on the lender’s knowledge of the market and the income and expenses of similar properties. If the construction costs are too close to the expected income of the project, it is a strong indicator the project will not be feasible and may be declined for financing.
Plans and Budget
The construction budget and pro forma are both critical elements in determining project viability. The owner/builder should present a detailed line-item budget that will be reviewed in underwriting to determine if it is reasonable. Construction budgets should include both hard and soft costs.
Hard costs will consist of items related to construction and other reasonable expenses incurred in the build-out of the project. These costs also encompass general contractor’s fees and other costs, including contract items such as bonding and construction insurance.
Soft costs include interest, fees, and other predevelopment costs. Soft costs also include a contingency account that must be contained in the budget to protect against unanticipated overruns. Costs payable to third-parties may include developer fees, leasing expenses, brokerage commissions, and management fees. These charges, if reasonable, may be contained in the soft costs.
The lender should review the budget to determine whether the project can realistically be completed as presented and how it compares to other recent projects of similar properties in the market. Lenders should be cautious of developers that submit budgets which either lack the necessary details or which appear overly optimistic. An experienced lender will rely on their expertise to recognize inaccurate budgets that could lead to excessive cost overruns, excessive change orders, and the eventual need to advance additional funds to complete the project. To the degree a lender does not feel it has adequate expertise in construction lending, or construction management in the desired marketplace, the lender is well advised to seek outside consulting parties to confirm the budget is realistic given market conditions such as local cost of labor, materials and delays due to any local government regulation.
The primary purpose of commercial construction is to create a profit for both the lender, the borrower, and the developer if different than the borrower. If the project’s budget allows little or no profit for the developer, there will also be no room for overruns, and it increases the chance the lender will have to take possession of an unfinished project. Additionally, the lack of available profit will complicate the lender’s ability to attract a prospective purchaser after completion. If this occurs, it may require the lender to dispose of the property at a loss.
The budget does not only need to be realistic as an overall plan, but lenders also need to examine each stage of the development carefully and should be aware of the practice of front-loading. Front loading is when a builder deliberately overstates the cost of the early stages of construction. When this occurs, and if the lender does not detect it at the beginning of the process, there will likely be insufficient funds to complete construction if there is a default.
Lenders need to monitor the progress of the developments they finance to ensure adequate funds remain to complete the projects. Obtaining regular reports and conducting site visits can help detect potential problems early. Although the budget should include an allotted amount for contingencies, they are intended for reasonable but unexpected increases in costs that can occur for a variety of reasons. Since some projects can take several years, it is not uncommon to experience increases in the cost of materials or overtime pay due to delays of shipments or adverse construction conditions. However, there are a few additional issues that can pose a serious threat to project completion.
• Liens filed by contractors, subcontractors, or material suppliers for nonpayment.
- Governmental interference and general NIMBY considerations.
• Failure of the contractor or a subcontractor to complete construction to specifications.
• Excessive cost overruns.
While some risks are beyond the control of either the lender or the contractor, many can be mitigated through careful analysis of the plans and budget as well as routine inspections. Regardless of the borrower, the lender should ensure the developer has sufficient expertise in their project and that the development is progressing as anticipated.
A Change in Plans
Quite often, change orders come up due to materials being no longer readily available, detrimental increases in costs resulting in using alternate suppliers or subcontractors, or any number of other reasons. Lenders need to have a skilled staff to monitor change orders and may elect to hire an outside consulting firm to review and give the recommendation of whether to approve changes. A significant number of change orders could indicate deeper issues with the project. Regardless of the number of change orders that may transpire, the loan must stay in balance.
Commercial Construction Loan Files
In addition to the project plans, feasibility study, and executed construction contracts and budget, a commercial construction loan file must contain a detailed loan agreement, which describes the rights and obligations of both lender and borrower. It should also cover the conditions for advancing any funds and the repayment criteria. The agreement must provide a provision to support the lender if the loan goes into default. The agreement ought to include a full budget, recognizing all costs funded by the construction loan.
The file must include a foundation survey that is completed after the foundation has been completed and before proceeding with additional work, to ensure it is consistent with the site plan and not encroaching on easements or other properties. Furthermore, all appraisals estimating the market value of the property before, during, and after completion should be included as well. Stabilization of occupancy should be predetermined and the file ought to reflect when stabilized occupancy is expected to be achieved. These documents, when reviewed and compared to the project’s timeline and budget, will assist the lender in detecting any potential problems early.
Lenders and developers need to set clear guidelines and expectations for both parties to the contract, and what constitutes a breach. The bank depends on the success of the project to earn a profit and does not want the developer to default. It is through scrutiny over the proposed budget and a meticulous monitoring progress throughout the various phases of construction that the bank can minimize their risks in the highly specialized field of commercial construction loans.