The economic purpose of developing a property is to create value above the project’s cost. A construction loan is specialized lending that requires a comprehensive understanding of the intrinsic risks associated with funding a project from the ground up. Commercial mortgage brokers should realize that construction lenders gamble in ways not generally seen in term financing of tangible real estate.
When brokers handle a construction loan, they should grasp why project evaluation, contractor review, underwriting standards and administrative controls are necessary steps for a prudent construction lender.
Figuring out how to implement a construction loan can be challenging because most of these transactions are underwritten without amortization. In addition, the full project value is dependent on securing collateral — and, in some cases, finding a buyer and long-term financing, like a takeout loan.
Construction lending is particularly sensitive to constantly changing market conditions. Consequently, a thorough market investigation is a critical aspect of the overall risk-assessment process.
A project evaluation addresses the components of a project and demonstrates the likelihood that it will be a financial success. These studies normally include demographics, market and feasibility analyses, a site review, a line-item budget and a contractor review. Lenders and brokers must realize that project-evaluation studies commissioned by a contractor or borrower may be subjective or biased, and should be thoroughly vetted.
The demographic analysis examines a project’s target population, and its density and growth potential. The market and feasibility analyses study the appeal and forces of the surrounding market, including its size, ongoing trends and growth rate, and then determines profitability for the new project. A site analysis confirms a project’s suitability for a specific location.
The construction budget is one of the most critical elements in determining financial feasibility. The budget must include detailed line items, which confirm realistic reflections of the planned costs. Lenders should be suspicious of budgets that lack detail or appear overly optimistic.
Construction budgets include hard and soft costs, as well as a contingency fund. Hard costs involve onsite and offsite improvements and building materials. Soft costs include interest and other development expenses, such as fees and related predevelopment charges. Remember, soft costs do not add value to a project.
Lenders and brokers should recognize two major risks in construction financing: First, the possibility of noncompletion and, second, the potential for the completed value of the project to not deliver enough value to repay the loan. Since the project’s anticipated value is not recognized until completion, a lender must judge the contractor and borrower’s ability to finish on budget, on time and on point with construction plans.
Before committing to the requested financing, a lender should analyze the contractor and borrower’s backgrounds, skills and financial wherewithal to ensure they have sufficient capacity to complete the project. Does the contractor or borrower have a track record of success on projects of similar size and complexity? Are they operating within municipalities in which they have experience and knowledge of local regulations and zoning requirements?
If the builder is a corporate entity, the lender and broker should know who the principals of the company are, and how long they’ve been with the company and in the industry. A contractor review should include a résumé detailing their experience, skill, training and education.
A lender must judge the contractor and borrower’s ability to finish on budget, on time and on point with construction plans.
Construction supervision is a critical part of a successful project. Contractors and borrowers should regularly visit the job site. Successful contractors try to visit all sites frequently and may spend 75 percent of their time in the field. Close supervision tends to keep projects on time and on budget. If the contractor and borrower are knowledgeable about the project, they can identify up-to-date costs and estimate completion dates.
Lenders who play a part in any segment of a construction project should require a comprehensive analysis and underwriting process to measure a project’s quality, identify risk and structure the transaction in a manner to mitigate as much risk as possible. There are basically two reasons why projects aren’t completed — insufficient funds or failure to perform on the part of the contractor or borrower. The underwriting process includes a review of the various factors for identifying potential problems.
One of the most influential ways to mitigate construction-loan risk is with borrower’s equity. Equity is important in guaranteeing a contractor or borrower’s continuing motivation to ensure the project’s success. Equity also provides a cushion for cost overruns. The lender’s policy should always require equity to be contributed before any disbursements of the construction loan. Financing only part of the project with the expectation that the remaining dollars will come from a different source is a weak procedure.
Credit policies should clearly define the types of construction projects, loan sizes and concentration limits that are consistent with the lender’s risk appetite. Policies also should include property types, geographic markets and other relevant factors. A key element in evaluating a project’s financial viability is a detailed pro forma statement. A thorough review of the pro forma statement is strongly advised to confirm the contractor’s and borrower’s assumptions are consistent with the cash flow of similar projects in the same market area.
Lenders will normally require several accounting and financial statements to determine the borrower’s ability to repay the loan. They include the following:
- Business balance sheet;
- Business income statement;
- Business cash-flow statement;
- Business tax returns;
- Analysis of liquidity and leverage;
- Personal balance sheet; and
- Personal tax returns.
Few lenders have the same administrative procedures. There are many ways to look at the same transaction. One thing, however, is consistent: Construction lending should never take a cookie-cutter approach. It’s a very paper-intensive process that requires assistance from many outside sources. Appraisal, title insurance, environmental assessment, land survey, surety bonds, property insurance and interest reserves are commonly used third-party reports.
Lenders should have a policy for using interest reserves in a manner that best serves the contractor and borrower’s needs while supporting their own institutional control requirements. Interest expense is a vital component of the construction-loan budget, and should be accurately estimated and funded until project completion. A lender should evaluate the rationality of the development assumptions, including potential changes in interest rates, the timing of anticipated disbursements and the total build-out time. For these reasons, lenders should closely examine interest-reserve estimates.
Lenders need solid policies and procedures dictating the loan-disbursement process. Controls should include inspection procedures, construction-progress documentation, and exception monitoring and reporting. A lender should never advance funds unless the money will be used solely for the project and in the manner required in the draw-request agreement.
Disbursement controls are an important element of construction-risk management. Lenders generally disburse loan funds according to a standard progress-payment plan. The plan should be structured so the amount of each draw coincides with improvements made on the dates of lender site inspections. A lender representative should periodically visit the site to guarantee work is completed as stated. A written report should indicate the work is consistent with plans and specifications, and should either confirm the project is progressing as estimated or warn the lender about potential problems, such as cost overruns or delays.
• • •
Change is never-ending and requires a strong commitment to industry knowledge. Lenders and brokers must be prepared to meet the needs of their borrowers and the significant challenges of the current market, tasks that can only be accomplished through education.