Ground-up commercial real estate construction is risky and almost always complicated, involving many steps, materials and people. The developer runs the risk of making costly mistakes that can delay projects for months or years.
In helping your clients evaluate opportunities and structure the financing, it is important for commercial mortgage brokers to know something about the construction process and its risks. A broker can provide added value by helping their clients build their projects on a solid foundation, and by making the right moves once the loan is approved and the project is underway.
Commercial-property development comes with great risks and rewards. Unfortunately, many developers and lenders are shocked when issues arise in the due-diligence, design and construction phases. Hidden problems cause scheduling delays and add significantly to the cost of these projects. Prior to seeking financing from lenders, it is imperative for investors and their commercial mortgage brokers to consider all the potential risks and roadblocks.
First, a developer needs to determine if the land is suitable for development and for the specific project in mind. At a minimum, your client should do a land survey and geotechnical inspection. Some of the most common, unforeseen and costly issues involve groundwater control, the presence of underground streams, and unsuitable soil or rocks. The land survey should assess the topography and boundary lines along with other site-specific details such as wetlands, buildable areas, subdivision platting, rock profiling, or the design of utilities and roadways to access the site.
The developer also will need to drill the lot to evaluate the soil and rock conditions, and determine the water-table depth. A developer could be surprised by the differing soil conditions across the site that may require rock removal, drying requirements or wholesale removal of unsuitable soils.
Soil composition varies widely by geography. The developer will need to consult with a local expert who understands the special properties of soils in the region, and knows how different soils react to loads, temperature changes and moisture. An experienced geo-technical engineer with an intimate knowledge of local soils can provide insight into the suitability of the property for its intended use and whether any preconstruction work is required on the site. Once this report is completed, you can confidently estimate the site-preparation costs.
Many developers, however, hesitate to spend money upfront for surveying and geotechnical explorations, and this mistake will often cost them time and money. Unforeseen soil work, for example, can add several months to the project timeline. A developer may have to obtain additional financing to complete the project. Ultimately, the investor must wait longer before the asset is producing income or ready to be sold, adding to the risks and lowering the investor’s return.
In a move to manage cash flow, contractors are often tempted to front-load the project budget, assigning higher values to earlier steps in the project so they receive early payment.
Schedule of values
The next step is to carefully monitor the schedule of values (SOV), which is a comprehensive list of work required for the entire construction project. The SOV governs the amounts and timing of the progress payments on the loan. You should track the SOV on a monthly basis, recording the contracted amount allocated for each line item and the percentage that has been paid out to date.
In a move to manage cash flow, contractors are often tempted to front-load the project budget, assigning higher values to earlier steps in the project so they receive early payments. This transfers risk from the contractor to the lender. If unforeseen problems with the groundwater or soil composition are discovered, the contractor can walk away without a loss once they receive payment in excess of their costs to date.
To mitigate these risks, investors and lenders often consult with an expert who can advise on the appropriate allocation of project costs in the SOV. This individual or company should have a wide breadth of knowledge across design, engineering and construction projects. Evaluate whether this professional is currently working on these types of projects, and if they can provide guidance on material and labor inflation in the current market.
A contractor, for example, might try to front-load half of the project, allocating as much as 50% of the total costs in the first three months of a nine-month project. A savvy consultant could spot this and flag it for the developer or their lender. The SOV could then be revised to allocate the appropriate cost to each line item. This would protect your client and the lender from carrying too much risk at the start of the project.
Contractors sometimes run into cash flow issues and take advantage of loan contracts that require payment for materials. In one extreme example, a cash-strapped contractor with two ongoing projects delivered steel to one project that was earmarked for another and then submitted the payment request.
Once he received payment, the contractor moved the material to the other job site where the steel delivery was originally intended. Without realizing it at the time, the lender was in a high-risk position. In this case, early and accelerated payments left insufficient loan proceeds for the remaining work on one of the contractor’s projects.
The developer and the lender should keep their agents close by. To mitigate risk throughout the loan, it is important to have continuous oversight of construction progress. Although it is not feasible for the lender to be on-site, they can hire an agent to be there and look out for their best interests. With any construction loan, lenders should determine how they will evaluate the work progress and confirm the percentage of the completed work as stated by the contractor for progress payments.
Consider hiring an inspector with knowledge of the construction industry, the local market and similar projects. This person can provide oversight on your behalf by visiting the site and evaluating the work progress. The more often you have an agent on-site, the more likely you are to avoid problems, such as when contractors exaggerate the progress on the line items in the SOV.
On a recent construction project, for example, the property owner hired an experienced consultant to conduct construction materials testing and special inspections. In this role, the consultant was on-site throughout the project. During this job, the contractor consistently overstated the completed percentage on the SOV. The consultant provided additional project oversight as well as monthly updates to the project owner and lender about the contractor’s true progress, and their ability to complete the remaining work on time and within budget.
Before approving a loan, lenders review the contractor and borrower for their experience and financial position, but it also is important for commercial mortgage professionals to understand the role of other parties involved in the project. A lender, in particular, typically needs a consultant to provide oversight and guidance that will help manage risk during a project. Keep in mind that the more often your agent is on-site during construction, the more insight you will gain.
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Before committing to a commercial construction loan, lenders and mortgage brokers must gain early insight into the risks and requirements of the project. Establish minimum requirements for due diligence before seeking financing or approving the loan, and then hire the right experts to manage your risk. By partnering with experienced consultants from the start, you will gain the knowledge needed to make an informed investment decision and set up your project for success. ●