Construction loans typically have numerous disbursements throughout their term. The loan agreement setting out the terms and conditions of the construction loan will specify any prerequisites the borrower must meet prior to receiving each disbursement.
Because construction loans are linked to ongoing building projects, there is a chance that a lender could forfeit its lien priority if a mechanic’s lien is filed based on work begun prior to closing or prior to a subsequent advance. And even if a lender’s lien position is secure, a post-closing mechanic’s lien can cloud title and make it more difficult for the borrower to refinance, particularly if litigation is needed to clear the lien.
The following is an overview of how lenders can leverage title insurance policies and endorsements to mitigate this risk.
Mechanic’s liens
This complication for lenders arises from the unique characteristics of mechanic’s liens. If contractors are not timely compensated for completed work, services, or products, then they are entitled to file a lien against the real property their work benefited for the total dollar amount due to them. Additionally, in most jurisdictions, the lien prioritization is determined based on the time at which the contractor provided (or started providing) the goods or services. Throughout the various stages of a construction project and after the issuance of the insurance policy, a lender’s lien priority could potentially be subverted via a mechanic’s lien if the contractor’s involvement started prior to closing or to the disbursement of any subsequent advances.
Protecting yourself against mechanic’s liens
Lenders can protect themselves against mechanic’s liens by negotiating with a title company to incorporate mechanic’s lien coverage into the title policy or to obtain endorsements to the title policy covering this issue. Failing to do so, and accepting boilerplate title insurance, could leave lenders vulnerable when it comes to protecting the favorable standing of their lien and to making sure the property stays clear of liens throughout the project.
The American Land Title Association (ALTA) standardized title insurance policy forms include coverage for mechanic’s liens that arise prior to the Date of Policy or following the Date of Policy if the insured party is required to disburse funds per the terms of loan agreement. Still, title companies are often hesitant to provide insurance coverage for mechanic’s liens when it comes to construction loans—mainly because of the elevated risk that a mechanic’s lien could arise over the course of a significant construction project.
Usually, construction loan title insurance policies will have clauses limiting the coverage amount to funds that have already been disbursed. Lenders must proactively request a ‘date down’ endorsement every time they make a disbursement in order to ensure that a mechanic’s lien hasn’t been recorded. Other types of pending disbursement clauses usually carry with them further requirements—for instance, some require the lender to provide lien waivers from the relevant contractors as well as proof that all debts are paid by the owner prior to the issuance of a date down endorsement.
Title policy endorsements
A construction lender should negotiate with the title company to incorporate specific endorsements pertaining to constructions loans into the title policy. For reference purposes, these are usually ALTA Endorsements 32-06, 32.1-06, 32.2-06 and 33-06. Broken down sequentially, these endorsements accomplish the following objectives for lenders:
ALTA Endorsement 32-06
This ‘Loss of Priority’ endorsement contains a provision for mechanic’s lien coverage for products or services on or prior to the Date of Coverage that have been contractually designated to be paid for in a construction project.
ALTA Endorsement 32.1/2-06
This ‘Loss of Priority-Direct Payment’ endorsement offers mechanic’s lien coverage for material or services paid by a lender by the Date of Coverage via a written agreement or otherwise.
ALTA Endorsement 33-06
The ‘Construction Loan Disbursement’ endorsement operates as a date down endorsement by altering the Date of Coverage. Furthermore, it amplifies the coverage of the title policy to cover for every pending construction loan disbursement.
Budget time to negotiate a title policy
Regardless of the exact type of policy and endorsements request, a lender should always expect that additional time will be necessary to negotiate a title policy for construction loans. Title companies are extremely wary of issuing mechanic’s lien coverage for construction loans and they will often require indemnity packages to be submitted, in addition to extra underwriting time. If a lender asks for title insurance coverage to account for potential mechanic’s liens, it should begin talking to the title company as early as possible and budget more time to complete the negotiations with title. Keep in mind that insurers weigh every policy individually and will almost always require additional documentation.
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