Most commercial loans have collateral which provides for a last means of repayment should the borrower default. The risk in a construction loan is the collateral could potentially be incomplete if the borrower were to default during the construction. For the sake of this article, I am considering a construction loan as one that vertically builds a structure from the ground up. Loans that horizontally develop land for development are also lumped into the same category as construction, but I consider those projects “development” with a different category of risk factors.
Nonetheless, having an incomplete building as collateral is an issue and a serious risk! How can an institution possibly control this risk? Naturally, the institution can put mechanisms in place to assure the building is completed. It is common practice for the institution to require the construction contract with the general contractor be assigned to the lender. In this way, if the borrower were to default, the lender can take over that project by working directly with the contractor to finish the construction.
Lenders can also obtain special guarantees and bonds that assure the project gets finished. A “completion guarantee” may be obtained from a third party, who will be a source of funding or labor should the borrower or contractor run into financial difficulties. A similar, but more formal, solution would be requiring a “completion bond” which is, in effect, buying insurance that guarantees the project will be completed.
Of course, having to take special efforts to complete the project is not ideal, but rather, a means of a last resort to shore-up a project. A strong level of due diligence before commencing on a construction project should do a lot to prevent the reliance contract assignments and completion guarantees. Due diligence will start with evaluating the borrower’s previous experience in managing past projects of similar complexity, but that is only the beginning. Due diligence should also be done to determine the contractor’s ability and history of completing past projects of similar complexity. Having a borrower and contractor that have proven track records reduces the likelihood the lender will have to take measures to complete an unfinished project.
Making sure the project is structured and administered correctly is also vital. In banking, a project must have a loan-to-cost of 80%, but will ideally be 75% or below. In the credit union realm, a project cannot exceed 75% loan-to-cost. These metrics are in place to assure the borrower has equity at stake and is sharing in the risk of the project. In this way, the borrower has incentive to see the project through to completion too.
Also, the lender should assure the borrower has some padding in their budget in the event of cost overruns and unforeseen events. This padding is usually referred to as “contingency,” and ideally, this should be 10%-15% of the total project cost.
The proper way to administer the project is to only fund work that has been completed, and to verify the completeness with an inspection. For example, say a borrower wants to draw on a construction line of credit to finance pouring the foundation on a commercial building. The lender will not advance money to the borrower and then later inspect that the foundation has been poured; but rather, the lender will make sure the foundation is already poured and complete, and only at that time will he advance funds to pay for the work done. And for good measure, the lender should also assure the subcontractor who poured the foundation does not have a lien on the property for the work performed, so the lender can keep a clear first lien position on the entire property under construction.
Monitoring construction projects can be time consuming and require attention to detail. Large institutions will have an entire department devoted to administering construction loans. If an institution is not capable of managing the construction monitoring process, there are third parties who specialize in providing these services. Of course, this will be another party the lender will have to perform due diligence on.
To summarize, a “vertical” construction loan has an additional level of risk than a typical real estate loan, but “horizontal” development construction is far riskier. The risk that needs to be managed in vertical construction is assuring the project is completed, so the lender is not left with an unfinished building as collateral. This can be done by taking an assignment of contracts or seeking a completion guarantee or bond. Before commencing the project, make sure the borrower has sufficient equity, contingency and experience. Make sure the contractor has experience, and experienced people are monitoring the construction administration process as well. With all these mitigating factors in place, the construction loan should only provide little additional risk to your portfolio.