Once a construction loan is closed and the mortgages are filed, part of the lender’s due diligence has ended but an entirely new part of lender work has just started. This adds a new layer of work for the lender, that if not followed, could result in a serious loss to the lender and pain to all those involved.
But first, we move back in time prior to our closing of the construction loan. The lender should have received the complete set of plans prior to closing, or at least prior to the first draw request that will occur after closing. The plans should be accompanied with a budget divided among the various divisions of construction as established by the American Institute of Architects. The contract should be inspected with vetting of the general contractor and obtaining any necessary bonding, workers comp, liability insurances required for the project. Any necessary permits should also be provided to the lender for the file.
A qualified third party, like an architect or engineer the lender employs, should be hired to review the budget and also provide periodic inspections during the construction period to verify the funds spent are actually spent in this project. I once had a house construction years ago that we had nearly 70% of the funds from the loan out when the project only had the foundation and first floor framing complete. Your architect should also provide a judgement with each progress inspection, if there are adequate funds remaining in the construction budget to complete the project.
The title company should also provide survey coverage, verifying that the building is set on the actual lot which you have as collateral. I once knew of a prominent realtor in a community who built his house over a property line boundary with his neighbor. What a mess that was to fix! The title company should also be lined up to handle disbursements and to provide a date down and lien search with each construction draw to make sure no supplier or labor liens are present. In some states, these builder liens take precedent over the lender’s previously filed mortgage or deed of trust. The title company should also oversee the lien waiver process and make sure that adequate lien waivers are executed and in their file.
So fast forward to after closing when you are in the throes of the construction process. Many of the commercial construction projects may require additional money to be put in from the borrower prior to the construction draw money from the lender. This equity should be tracked and run through the title company, just like any other draw funds that the lender would provide.
In addition to each draw being run through a title company to make sure no liens have arisen; each draw should be monitored by your third-party inspection. The inspection should also contain multiple picture of the property and a detailed inspection of the draw, funds spent to date, and funds remaining as lined up with the original budget. Explanations of any change orders and the cost impact should be provided. At times, these may require the borrower to bring additional equity into the project. The worst case is when the borrower is out of resources and additional lending funds must be obtained to complete the project.
Now there are some lenders who want to take on these roles that I suggest being completed by the title company and architect. While a field lender may be fine in overseeing a small construction loan, larger, and complex commercial loans should utilize competent third parties for inspection, title work, and disbursements, unless the lender has a dedicated staff who can handle these duties. Yes, there is a cost for these services, and this should be passed on to the borrower. This is just part of the cost of doing business.
Utilizing an outside architect should not be an excuse for the lender to not visit the project. Borrowers love showing off what they are building. A few inspections of the site with the borrower often yields invaluable insight into your client.
Prior to the final draw, the lender should be provided the certificate of completion or occupancy for the project, and any business licenses for the company, if needed. If the project is completed in the winter, this may be a temporary certificate in nature, often with the requirement of certain landscaping to be completed prior to the final certificate. Any temporary certificate should be understood for what items are required for completion in the eyes of the jurisdiction, and, if necessary, funds should be held in escrow with the title company. The amounts for any disputed bills with the contractor should also be held at the title company in escrow, so you can obtain a title policy with all builder’s or mechanic’s lien coverages for your institution.
Any commercial construction loan requires much work in monitoring prior to closing and during the construction process which requires the lender to adhere to best practices in proper management of the loan. Deviations from these may expose the lender to additional risk. If you need help, contact us. We manage construction loans and can help.