As someone engaged in business lending, I must be an armchair expert on a wide array of topics. How can someone like myself feel comfortable reviewing loans related to agriculture, hotels and cinderblock manufacturing when I’ve never farmed, made a bed, or operated any heavy machinery in my life? It takes years of experience, but a solid knowledge of economics and finance can help you predict how these operations should behave, and then astute observation of past performance can help you corroborate those expectations.
Construction projects can be especially risky, because of the prospect of cost overruns and the fact we have no initial collateral in place. So, if you have never swung a hammer on a job site, how do you know if the construction request in front of you has any merit? Some common sense details can help us cut through most of the uncertainty.
First, you need a project budget, which we refer to as a “sources and uses” budget. In other words, we want a budget that shows all the project related expenses, and then a list of all resources provided to pay those expenses, such as personal cash, loans, etc. Sources must equal uses. And there are some common expenses we know to check for on the “uses” side that are often overlooked and can materially affect the lender.
I particularly check for whether interest expense is budgeted to pay for the subject construction loan. The longer construction takes, the bigger this will be and more burdensome to boot. So, we need to make sure there is enough interest to pay for the loan until the project begins to produce cash flow.
Another item we need to check for is “contingency.” This is a catchall for unforeseen expenses. If it is small relative to the entire budget, it means there is little room for error. If it is particularly large, it may be treated as a slush fund for nonessential items. Generally, contingency should be between 5-15% of the construction budget. It may be okay if there is little or no contingency, so long as your guarantors have substantial personal liquidity reserves that can easily meet the same 5-15% test.
How do you know if everything in the construction budget has been estimated correctly and captures all necessary items? We will require a bid from the contractor(s) to corroborate the actual cost. If our sponsor is the GC, we may have a third party contractor or engineer evaluate the budget provided to get an expert opinion regarding the accuracy of all the expenses. A good appraisal should help corroborate this information as well.
If a third party contractor is utilized, it is also common to ask that the contractors be “bonded” or carry insurance to make sure their work is completed with an expected level of quality. Sometimes, general contractors are even expected to provide a “completion guarantee” to assure the project gets done.
There are additional underwriting details to evaluate when looking at a construction project, but look at how much risk we have already started to get our arms around. While we may have no personal experience at a construction site, we have already assessed what resources are available and where additional resources can come from. We can also make sure the contractor has the ability to deliver and verify their estimates and assumptions. In doing this, we show risk management isn’t about having deep knowledge about a specific topic, but rather having framework for dealing with unpredictable events and different kinds of uncertainty.