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Danger signs for construction loans: construction loan workouts don't have to be fatal. With a little forewarning, potential problems can be resolved.

Danger Signs for Construction Loans

Construction loans may go into non-performance status for a variety of reasons. The myriad of parties involved, including the developer, the builder, the investor and various subcontractors, can keep a lender running in circles just trying to keep up with the project's progress. There are plenty of warning signs, however, that lenders can watch for, to guard against potential losses. Importantly, if problems arise, the lender should be ready to tackle them early--to cut losses and turn the property around while there is still time. Implementing a system of "red flags" is essential to be able to assess what to do about incomplete projects.

Losses that are unaccounted for should be caught as soon as possible--they could indicate that the original estimates weren't on target, or in a worst case situation, that wrongdoing is taking place. If honest cost overruns are involved and detected early enough, the wisest decision you may make is to abandon the job entirely. Abandoning a 20 percent advance construction loan may be less expensive than abandoning an 80 percent complete job. True, you must operate within your loan documents, but evaluating where you are and the cost-to-complete will help you decide. Even if you cannot legally abandon the loan, it may be less expensive to buy your way out or to use the personal guarantee to get cooperation.

How do you tell if there are going to be cost overruns, overdrawn jobs, dissatisfied trades people or poor workmanship? Most of these symptoms appear long before the project falls into default. In troubled times, you should be constantly updating construction progress in the field, comparing loan balances with the projected cost-to-complete and making certain that subcontract balances are sufficient to bring the job to physical completion within the balance of the loan.

Field work

A lender's physical presence in the field is important. You cannot evaluate a development and construction loan by sitting behind a desk. If you or your staff visit the site and see it humming with contractors, you can see that things are moving according to schedule, especially if the paper work ties it together.

But, if you visit the job and discover few people working and few trades people on the job, you might have a developer who is unable to pay his bills and whose subcontractors are walking away in droves. The lender or the local representative, mortgage banker or correspondent should then take the opportunity to talk to the subcontractor and to other local lenders to inquire about other jobs that the developer is involved in. Are the other jobs of this developer moving according to schedule? Find out what local renting agents, suppliers, commercial lenders, subcontractors and material suppliers say about this developer.

A construction loan does not die suddenly. It slowly gets sick and gradually worsens. If the lender or someone representing the lender is out in the field looking at the job site and making inquiries, the symptoms may be discovered long before the fatal end.

Sometimes just walking around the job site is an eye-opener. Also, it may be useful to audit the developer's books if you have the legal right to do so. Sometimes a lender may be surprised to find out that the developer keeps no books, has no system of controls, no idea of when the job will be done and how much it will cost to finish it.

If the lender uses architectural inspectors on site, they can be of help. After regular visits to the site, they should be able to estimate the cost to complete the project and compare it with the undrawn loan balance. Inspectors should be able to provide information about local trends, activities, competition, and the like. In some cases, they may be able to get more information on a casual basis than you could get on your own. The developer is used to seeing architectural consultants on the site; a visit from his lenders may make him suspicious, and he may be less-than-willing to talk. Similarly, a local mortgage correspondent may be in a better position to do subtle detective work than you. In any event, someone should be visiting the site on a regular basis.

What kind of financial information should the lender look for? Not only should the lender know the status of your job, but also the status of the developer's total current cash flow. This refers to his total cash flow budget--not just the cash flow on your job. It is not uncommon to see one job proceeding nicely, until the developer or his subcontractors begin to use the mortgage payments to work out other developer jobs that are in trouble. Even when there is no diversion of funds, if the developer is not paying his subcontractors on other jobs, then he may not be able to retain workers for the your job. The developer's reputation is critical to complete the project, and the lender needs to get the full picture: a sick developer cannot deliver a healthy job.

Workout strategies

If a visit to the site indicates that the construction loan is clearly going bad, several courses of action can be taken. A development and construction lender has some problems that a permanent lender does not have. Your first decision must be to "lock everything up" to prevent any property from getting stolen, destroyed or vandalized. Once the lender decides to foreclose, this is one of the first steps to take, even before deciding on a permanent solution. The lender must take control of the situation as soon as possible (within the terms of the agreement) making sure that the on-site materials do not get picked up by unhappy subcontractors. Also make sure that unscrupulous neighbors do not help themselves to refrigerators, washing machines and other portable building supplies. Reputable guard service is often required. Taking precautions to prevent weather damage may also be necessary. If the lender does not have the right to order these actions, they should be negotiated.

While preparing a cost-to-complete analysis, it is necessary to make sure that your building permits are being kept current; that they are either transferred or transferable. Similarly, architectural agreements and subcontracts should be transferred or transferable. Because it may be difficult to work with the developer, once the lender takes possession, the lender should try to elicit cooperation from the borrower early-on, during the negotiation stages. There is time to negotiate the transferability of contracts while he is asking for extensions of time, interest rate relief or other assistance. At that time, the lender should lock-up or modify the paperwork to accomplish transferability and control.

The existing subcontracts should be reviewed, together with a cost-to-complete analysis. Lists must be prepared for work completed and paid for, and someone--probably the architectural consultants--should make sure that there have not been any unauthorized substitutions or downgrading of materials. If that is the case, find out who was responsible and what can be done about it.

Check the validity of the existing subcontracts and the credit standing of your subcontractors. Do they have any payment problems themselves? If so, the lender must consider alternative subcontractors for the job. However, in many cases, the options will be limited, depending on the local area and how much control the subcontractors have over the local union and labor supplies. The advantage of retaining existing know-how on your job rather than bringing in someone fresh must also be considered. Still, alternative subcon-tractors must be considered, if for no other reason than to give the lender a negotiating posture.

Cost to complete

The cost-to-complete analysis must be reviewed with a new hard-nosed attitude. While we began this discussion by saying that the concerned construction lender was to "lock it up" and "think it through," this simply means taking control; not necessarily stopping the job. That means taking inventory, to make certain you will not be charged twice for materials that disappear, or for work that has already been completed and paid for once.

In some cases, the lender will want to speed up construction, even if expensive overtime is involved, to meet a permanent mortgage deadline that may take the loan out. The lender may also need to speed it up to meet an AAA-1 leasing deadline. In other cases, the lender may want to slow down the job to recognize the realities of an oversaturated market.

Foreclosure is the standard against which all other procedures are measured. The cost and the time needed to obtain good title by foreclosure must be considered. While taking a deed in lieu of foreclosure is speedy and inexpensive, the lender must ask what he is sacrificing to get it. A deed in lieu of foreclosure will not cut off mechanics' and material suppliers liens or possible third-party creditors. If these claims must be wiped out, you may have to go back to the longer, more expensive foreclosure proceedings.

Even in the case of a foreclosure, the lender may decide to pay for assignments, documentation, re-execution and waivers and releases from the borrower. There are an increasing number of lender liability lawsuits by borrowers claiming they have been defrauded by the lender, so it becomes important to decide whether it is easier and less expensive to pay for releases and do the foreclosure against third parties, such as subcontractors, or litigate with the borrower. Each case has be considered on an individual basis after considering all the options.

Early warnings

Successful loan workouts are helped by early warnings; the sooner the problem is spotted, the easier it is to solve.

The best way to spot troubles early is to get out in the field. If the lender cannot do it, a local representative should.

Once you conclude that you have a problem loan, start negotiations with the borrower. Because the lender and the borrower are at an early negotiating stage, they should still be looking for each other's cooperation--and that is the time to get it. Obviously, there will be no favors from the borrower once foreclosure or other types of litigation are started. However, while he still has hope in the job and is asking to extend or ease the loan terms, get his cooperation.

Also in the early stages, the lender may be able to get the borrower to reaffirm the loan, waive alleged breaches of the loan agreement on your part, get a release of claims that the lender has defrauded the borrower, get the borrower to counter-sign documents that have missing signatures or get the borrowing party to sign UCCs that someone failed to file.

In other words, a loan workout does not start with a lawsuits; it starts with negotiations. During those negotiations, make certain you get something back for liberalizing the loan terms and cooperating with the borrower. Once hostilities start, you will get nothing "for free."

Daniel S. Berman is a member of the firm of Fink Weinberger p.c., of New York City and White Plains, New York. Mr. Berman has delivered lectures to the Mortgage Bankers Association, New York University's Real Estate Institute, National Association of Home Builders and the Apartment Construction News Convention. He is the author of five books and a number of articles on real estate workouts and bankruptcies.
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Author:Berman, Daniel S.
Publication:Mortgage Banking
Date:Aug 1, 1990
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