The Risks of Construction Lending

Although the seeming speed with which new developments spring up around the country makes construction look straightforward, it is not if done correctly. The average construction project usually involves many risks, both to the lender and borrower, and having a successful project often depends on how well the risks are managed.
 
It is no surprise that lending on construction projects carries substantial risks. Many things can go wrong, and any one of them can cause a significant loss to either the lender or borrower, leading to disputes between parties. Other parties not related to the transaction can also be negatively affected. This could include condominium owners in an unfinished project. Contributors to loan failure may consist of:

• Project delays
• Project going over budget
• The collapse of product demand before the end of construction
• Fundamental design, compliance, or oversight errors
• Character, expertise, and financial standing of all related parties
• Misdirection of funds and resources
• Borrower’s discretionary changes that alter the project scope without the lender's knowledge
• Environmental or site conditions

 
When these problems occur, disputes between parties are not usually far behind. In most cases, these disputes require a construction lending expert witness in the arbitration, mediation, or litigation proceedings that would usually follow. The expert helps clarify the issues, including the burdens on either party or how well these were discharged.
 
However, a more critical consideration for parties is limiting their exposure to construction risks in the first place, usually with the help of a construction risk management expert. With lower exposure, parties can more easily manage risks and attend to issues as they arise.
Drivers of Construction Risk Management
The market experienced a downturn after the Great Recession of 2008 but picked up the pace until the Covid-19 virus impacted the economy and the lending environment. Due to the experiences of the recession, more lenders are actively implementing lending risk management strategies. Other drivers for lenders’ construction risk management include:

• Greater regulatory scrutiny: Bank lenders are required to impose stricter controls on their construction lending process. For instance, regulators now require banks to maintain capital for a new designation of commercial real estate loans referred to as High Volatility Commercial Real Estate (HVCRE) at 150%.
• Need to avoid loss: This is a primary motive for all lenders. There is an understanding that leaving holes in their risk management process will eventually result in a significant loss. As a result, lenders must be diligent in their risk management.
• Changes in policy: Policy changes result from several driving factors, including “proactive policy management” and the need for better internal controls after an expansion.

Regardless of the motivation, the endgame is the same for all lenders: to limit risk exposure and have proper controls in place to limit exposure should problems arise.
 
Managing Construction Lending Risk
 
One of the common means through which lenders manage risk is by establishing and maintaining a Real Estate Construction Administration (RECAD). Whether the lender's appetite covers just owner-occupied real estate, real estate developer-investor opportunities, or commercial real estate as well, having a RECAD function is a prudent risk management practice.
A RECAD unit conducts oversight and monitoring of construction projects financed by the lender. A million and one things can go wrong with a construction project. A RECAD unit’s task will be to keep an eye on every risk factor relevant to the project to ensure the project stays on track. The unit’s responsibilities will include:

• Pre-closing activities could include:
  • Verifying leasing and pre-sale information
  • Obtaining and vetting copies of crucial documents related to the project such as permits, plans, specifications, and written building contract
  • Investigating the character, expertise, and financial standing of all related parties
  • Obtaining an appraisal or valuation depending on the project size
• Post-closing activities, including:
  • Reviewing funding draw requirements under the construction loan agreement (Standard Payment Plan: pre-established schedule for fixed payments or Progress Payment Plan: monthly disbursements with a portion held back until the end of the project)
  • Arranging progress monitoring through a qualified professional
  • Reviewing the construction risk assessment report
• Construction administration and monitoring activities, including:
  • Reviewing change orders and ensuring appropriate use of funds
  • Coordinating periodic progress monitoring, obtaining picture documentation, and escalating any issues as appropriate
  • Receiving waivers of lien as payments are made on the project
• Post-construction tasks, including:
  • Coordinating conversion of insurance from builder’s risk to hazard insurance
  • Coordinating loan status change from a construction loan to a permanent loan on the lender’s balance sheet
  • Managing final waivers of lien
  • Obtaining a Certificate of Occupancy

 
Conclusion
 
Lenders commonly utilize the services of a construction risk management expert to consult on and, in some cases, oversee the setup of a RECAD department. Regardless, a fundamental recommendation is that the department is given as much independence from the real estate lending function as possible. This separation allows clarity of purpose and a coherent function on the part of the unit.
 
Construction loan risk programs are critical for profitable lending.  Properly structured Real Estate Construction Administration Departments reduce risks for lenders. Should disputes occur, much would depend on how fault can be apportioned between parties or whether both parties sufficiently fulfilled their obligations; a construction loan expert witness can help educate the parties involved, and if necessary, the court to clarify these issues.