Digging into the nuts and bolts of construction loans.

A construction project does not begin when the golden shovel breaks ground. Long before the building begins to rise, a developer will have secured the financing necessary to move the project from concept to construction.

This article will review the purpose of construction financing, describe some of the risks involved, outline the typical steps in obtaining a loan agreement, and offer tips for maximizing the value of outside legal counsel in this process.

Construction financing helps borrowers achieve three primary goals: the purchase of land; the development and construction of improvements on the land; and the operation and management of specific projects (comprised of the land, buildings and facilities that have been leased).

Lenders typically underwrite projects through short-term credit facilities. These facilities usually have a duration ("maturity") of 12 to 36 months. Loans are often structured as advancing term loans; that is, borrowers are given monthly "advances" or draws, the delivery of which ends before the loan matures. Under certain circumstances borrowers may obtain one or two extensions in periods of six or 12 months. However, the principal borrowed will begin to amortize during this period; 25- or 30-year amortization schedules are typical.

Loan amounts typically total approximately 50-85 percent of the appraised value of the completed project. Alternatively, loans may total 70-100 percent of the total cost of the project as evidenced in an approved construction budget. Federal regulations require lenders to obtain an independent appraisal of the project's expected value upon completion.

Lending institutions that maintain federally insured deposits must remain within certain limitations on the maximum amount of the loan, as a percentage of projected value. Known as "supervisory loan-to-value limits," exceeding these ratios automatically initiates various reporting and other requirements that lenders typically prefer to avoid.

Of course, construction loans are not entirely risk-free. Some of the risks that must be addressed in the negotiation and documentation of the loan include:

Failure to complete construction. Lenders often ask borrowers for completion guarantees or performance bonds. Obtained by the borrower from a commercial surety or bonding company, these provide a third party to which the lender can turn, to ensure completion of the project and to cover any excess costs of completion.

Failure to pay materialmen. Lenders also seek protection against the possibility that borrowers will not pay subcontractors. In most cases, lenders withhold up to 10 percent of each draw to insure payment of contractors. Lenders may also write loan provisions that allow them to pay subcontractors directly from the proceeds of the loan, or require payment bonds, borrower's deposits or lien waivers, among other terms.

Inability to lease space. Often, the funding of loans and delivery of advances will be conditional upon the percentage of executed leases during the construction project. Debt service coverage tests are also used to condition funding upon certain levels of net operating income.

Inadequate source of repayment. To minimize risks to final repayment of the loan, construction lenders may require commitments from permanent lenders. These include forward loan commitments (which commit the permanent lender to a future loan, subject to certain conditions); buy-sell agreements (in which the construction lender agrees to sell the permanent lender all rights and title to its loan); and extension options (which are incorporated into the original loan documentation and may include long-term extensions, or "conversions").

An effective construction loan agreement spells out clearly the actions that must be carried out by all parties, the schedule of these activities, the conditions under which the activities must occur or can be modified, and the specific dollar amounts in question. Although many construction lenders have internal guidelines regarding commercial construction loan applications, approvals and documentation, these policies are not enforceable by law against a borrower unless they have been incorporated into the loan documentation.

Many lenders supply forms that attorneys and borrowers must use for each transaction. These forms should be reviewed in order to ensure that the final documentation incorporates the lender's internal policies as well as any federal, state and local statutes that apply.

Outside legal counsel can play a critical role in ensuring that the loan documents--a legally enforceable agreement--accurately reflect the client's objectives and intentions. This due diligence includes the creation of all supporting documentation, including checklists, term sheets, disbursement schedules and procedures, guarantees and protections, assignment of rights, and the like.

Borrowers should seek outside counsel with complete familiarity with all federal, state and local regulations relating to construction loans and real-estate development projects.