Private construction lending – avoiding pitfalls to reach that higher yield

May 21, 2019 by Paul J. Sievers, Esq.

Over the past decade, fix and flip real estate lending has boomed. The non-conventional lending industry filled the financing gap created by the failure of the sub-prime lenders and traditional banks who were tightening their lending standards.

This opportunity led to an explosion of non-conventional lenders in this newly redefined space, ready and willing to fund the acquisition and rehab of homes for established real estate investors. As the foreclosure glut dries up, however, and under-valued homes become rare, an overcrowded field of non-conventional lenders is struggling to find fix and flip deals that provide the type of yields to which they and their investors have become accustomed.

As non-conventional lenders look for new markets in which to participate, ground-up construction lending offers a great opportunity with an upside that generally offers a better yield than traditional fix and flip financing.

Construction lending can be profitable, but as with most opportunities, there are pros and cons. Here, we explore some of the benefits that construction lending offers non-conventional lenders, as well as the pitfalls lenders must avoid in protecting their investment.

Underwriting Construction Real Estate
On paper, construction lending appears to be an exceedingly risky proposition. However, if you understand the moving parts and manage them with a mindset of reducing risk at the start of the process, it can be extremely lucrative.

Project and Contractor Feasibility
The first, (and most important aspect), of underwriting a construction loan is ascertaining the proposed project’s feasibility. Even assuming a large profit potential on paper and a proven track record with the potential borrower, the lender must take a hard look at the project specifics. If an analysis of a project feasibility isn’t done correctly, and the costing analysis isn’t done properly, the loan is headed toward foreclosure before the first nail is driven.

Underwriting is the time to ask hard questions, not simply rely upon the past success or credit-worthiness of a proven borrower. After all, the lender and the borrower are not the only factors in this equation. If the borrower hires a lousy contractor, for example, the project may be in trouble before it begins. So, one integral part of the process is underwriting the contractor who is going to complete the work. Obviously, the prudent lender needs to ensure the contractor is competent, insured, licensed, and has verified that the contractor has previously completed projects of the same size and scope.

The lender also needs to look at the contractor’s financials. Can they support the job? Can they pay their workers? How long have they been in business? How many projects are they working on concurrently? These are questions that need to be asked and answered before the lender has committed to making the loan, because it’s common for overtasked and overleveraged contractors to begin drawing down funds on one job to make up for cost overruns on another.

Scrutinize the Scope of Work
Detail is everything when evaluating the Scope of Work. When determining the value of the property that will secure a construction loan, the details provided in the scope of work are critical. Unless one knows the line items, with all of the details included for each, how can an appraiser make a proper cost approach valuation?
How does the lender protect itself? The lender needs to go through the scope of work, and identify each line item that is lacking detail, requiring additional information that will help the lender come up with a more accurate valuation. All construction, down to fixtures, lighting, and countertops, needs to be identified and each line item needs to be detailed.

Understanding the importance of the scope of work, and ensuring that all the details have been provided, is the key to permitting the appraiser accurately evaluate the project correctly and provide the lender (or his or her investors) an accurate risk assessment.

Post-Closing Management
After the construction loan closes, the work is just beginning. Once underwriting is complete, the key to a successful construction loan is managing the budget. Hopefully, the lender, borrower, and contractors now have an approved and solid budget. The budget must stay the budget! The lender evaluated the loan based on the approved budget, lent on it, and now the contractor and borrower must adhere to it. Period.

When a contractor sends in a draw request, the lender will need to conduct a site visit to ensure the work the contractor says is done really is complete, or nearly complete. The lender then collects invoices and lien releases, determines that all of the work of that subcontractor has been completed, and makes sure all subcontractors get paid by the contractor. This process is critical because the lender doesn’t want to be making a subsequent draw in order for the contractor to pay a sub he should have paid during a previous phase. Worse, the job gets completed, and the lender starts getting calls from subcontractors or suppliers looking for payment for services or materials rendered.

An active funds control process needs to be in place (prior to funding) to manage payments, verify the work has been done, review and check invoices to make sure subcontractors and materialmen have been paid, and ensure all liens get released. Most lenders don’t have the staff to take on this challenge, choosing instead to utilize the help of a third-party construction management company to oversee construction-to-perm financing deals. This is the best investment a lender can make.

By not going through these steps correctly, the lender risks having a subcontractor’s mechanic’s lien cloud title, ultimately disrupting or delaying a sale of the property. Even worse, the lien may hinder the lender from doing anything at all with the property, forcing a foreclosure (or requiring that the lender or borrower “bond around” the lien). Now, the principal of the loan is tied up for four-to-six months while the lender sorts this all out. So, one can see the challenge and critical importance of carefully managing all aspects of a construction loan post-close.

Draw schedules agreed to by both the borrower and contractor are of particular importance. Poor fund control could lead to severe issues in meeting construction schedules. If a lender isn’t managing the draw schedule against the construction schedule and scope of work, the lender could end up being 60% drawn on a project this is only 30% complete.

If the project becomes overfunded in this manner, the contractor will have insufficient funds to complete the project. The lender is then faced with a difficult choice. Loan more funds or foreclose on an incomplete project? As any lender should see, simply sitting back and blindly cutting checks from the fund reserve (hoping for the best) is not an option.

By getting involved early and having a plan in place that strategizes working with the borrower and the contractor to ensure they stick to budgets and timetables, the lender will be in a better position to steward a lucrative construction loan through to completion.