Reducing the risks in construction lending.

Wars, depressions and other calamities always have been crucibles for change and the just post-recession was no exception. The hard times that struck the nation's real estate lenders are again producing the new momentum for real estate lending.

While there is still little agreement on the exact shape that reforms should take, most practitioners believe that the first step must be a reaffirmation of basics, the "nuts and bolts of real estate construction lending."

No lending is without risks. This is especially true of real estate construction lending. Unfortunately, until our recent recession, prolonged prosperity seemed to have anesthetized our sense of the risks incurred by the lender who is providing construction financing.

Primary Risks of Construction Lending

Two primary risks are inherent to a construction loan. First, there is the danger of non-completion of construction. A construction lender should be aware that after he has disbursed the first dollars of the loan, there is no way by which he can be repaid from the real estate until the construction is completed and the value of the real estate can make repayment possible.

Second, if the proposed project is not economically feasible, its value upon completion will not provide a means of repayment. The construction lender who has not considered the real estate and its value as the ultimate source of repayment has failed to exercise the prudence required by his fiduciary institution. Long-term mortgage commitments are comforting, but they exist as a result of the value of the real estate when it is completed and is operating as a "going concern."

Causes of Construction Non-Completion

There are six major reasons for not completing a project, as follows:

* Insufficient funds with which to complete the construction is the most common problem. Builders run out of funds for one or more of the following reasons: Underestimated cost of the total project; poor capitalization at the start; increased costs during construction; lack of early rentals; and cash drain caused by borrower's other projects.

* The business failure of borrower or principal is a second cause of non-completion. Adverse business conditions experienced elsewhere by the borrower can seriously jeopardize the well-being of a healthy project.

* A contractor's or subcontractor's failure to perform is a third cause of non-completion. A substantial amount of time and money may be lost if the general contractor or a major subcontractor cannot continue to perform the terms of his contract as a result of spreading himself too thin, financial problems, increased costs, lack of material or non-qualified personnel. It is difficult for many reasons to replace a contractor once he has started on a project.

* Strikes, especially at a critical stage of construction, can effectively close down a project and be a contributing cause of non-completion. The rescheduling of trades involved in a project often causes a loss of momentum which is never regained.

* Unavailability of material is also a cause of non-completion. Sometimes there are problems with timely delivery of items such as ready-mix concrete, or an inability to find a manufacturer of special-sized components for a unique type of construction.

* Destruction of the improvements is a danger with which every mortgage lender must live. Fire, wind or other catastrophes may destroy some or all of the project. The resulting loss of time, material labor and value created cannot be borne by either the borrower or the lender.

The Whys of the Risk of Economic Feasibility

In addition to the ever-present danger of non-completion of construction, there is also the risk of economic feasibility. Failure of the real estate to achieve the economic success that was envisioned at the start of the loan may be the result of poor location or design, improper pricing of rental or sale units, underestimating expenses, or a combination of all these and other reasons.

If the economic success of the real estate was thought to be assured by firm leases prior to the start of the project and the amount of the construction loan reflected the leases or the credit of the tenants, the business failure of the tenant could substantially change the economic value of the real estate and cause it to lose its economic feasibility.

Changes in the money market can also cause a property to become economically unfeasible. We all know the disastrous effects that a change in the cost or availability of money has on real estate. An increase in the cost of short-term money generally causes an increase in the construction loan interest. The result is an increase in the total cost of the project. An increase in the long-term cost of money makes long-term lenders reluctant to fund their previously issued commitments. The heavy fees which must be paid for extension and the higher cost of long-term money cause an increase in the capitalization rates which determine economic value. All these changes have as a net result a real estate project which costs more, but may be worth less.

Risks Resulting from External Events

In addition to the primary risks inherent in the construction loan process itself, certain risks incurred by a construction lender are external to the project. Projects have been delayed, stopped or substantially altered as a result of community action. Occasionally, legislation affecting construction already underway is enacted, which adds to the cost of construction and, in some cases, affects the economic feasibility of the property.

Environmental controls are the source of many uncertainties. Many developers are just beginning to learn how to deal with them. All these risks are real. They may affect any construction loan. There is no way to completely eliminate them. However, to the extent that they are recognized, a prudent lender can limit his exposure.

Reducing the Risks of Construction Lending

The most successful way to reduce the risks of construction lending is to become a "shirt-sleeve lender," with mud on your shoes and a strong appetite for detail. A good construction lender does not make or buy construction loans without first "working the numbers" personally, making a site inspection and assuring himself that no detail has been left to chance.

The foresighted lender demands that each borrower submit a complete package of needed information before he completes his underwriting and issues a loan commitment. The underwriting is done with the risks of non-completion and economic feasibility foremost in mind.

Completion of Construction

Assuring the completion of construction starts with an independent estimate of construction cost by either the lender or an outside construction expert. This estimate of cost should include not only the "hard costs" of brick and mortar, but also the "soft costs" of construction loan interest and the startup costs of carrying the project until a positive cash-flow is achieved.

If the construction loan that is justified by the value of the real estate is not sufficient in amount to provide for the total of hard and soft costs, the construction lender must then look outside the real estate for additional value. The difference might be provided for by equity funds. If this is the solution, a prudent lender will require that those funds are to be used first, before the construction loan is funded.

A good general rule is to require that all construction loans be guaranteed by the principal. If the financial structuring of the loan is weak, a third-party guarantee is sometimes helpful to insure that extra dollars will be available to complete a project which has experienced a shortfall of funds during construction.

A knowledgeable lender is also aware of the fact that subcontractors are not paid in full in each requisition. There is usually a retainage of some amount. A construction loan should be structured so that there is a holdback of loan funds until the completion of construction to pay for these retainages and to avoid mechanics' liens. The long-term mortgagee expects a finished building, and therefore, construction funds should be held back for tenant finish or furniture as, for examples, in the case of a hotel or nursing home.

Where the lender has concluded that the general contractor or major subcontractors are weak, the insistence an performance and payment bonds adds the weight of a surety company to that of the contractor. The merits of the bonds are only as good as the completeness of the construction documents (contract, plans, specifications and amendments).

Know Your Borrower

Since the construction lender cannot be protected by the value of the real estate until the raw land is transformed into the planned project, the borrower and his entrepreneurial talents are a key element in the lender's security. If the lender does not have a longstanding relationship with the borrower, he should gain insight into the borrower's character and business before committing to lend. Other construction lenders, long-term lenders, bonding companies, contractors, and other professionals are good sources of information on the borrower's capabilities.

Complete and timely financial statements should be obtained from the borrower. However, a real estate borrower's statement can be as deceiving as a mirror in the fun house of an amusement park. Each asset and liability should be questioned and understood. The lender should be wary if no contingent liabilities are listed. Market values should be independently checked, and the certainty of all cash-flow explored. Real estate investors have the happy faculty of "counting their chickens before their eggs are hatched" when preparing a financial statement.

Furthermore, the lender must not forget that the Internal Revenue Service has a prior claim to all income and profits before the borrower can use them to fund a cash requirement of the project.

The lender may be well-advised to meet the borrower's personnel and visit projects which the borrower has built or is presently building. The finished project will indicate not only the borrower's construction abilities, but his real estate marketing and management capabilities.

Few people achieve success without experiencing adversity at some time. The ability to handle adversity and the manner in which it is handled is a good means of evaluating an individual's character and capacity In this regard, the borrower's affiliations are important. Does he belong to enough business and social clubs to know all the potential tax investors in his community? Does he have family ties which could provide help if needed?

A lender who lends in an area new to him adds to the normal risks of construction lending. Each state has different lien laws, and the lender should be familiar with the laws which govern each loan transaction. Local areas have unique problems which could cause delays during construction.

It is helpful to have a local lender as a lead lender with whom you can participate - but he must be familiar with the availability of labor, materials and other considerations which might affect the scheduling and completion of construction.

Unforeseen Losses

The only way a lender can protect against unforeseen losses is to require adequate insurance coverage on the improvements. This coverage, usually in the form of an all-risk builder's policy, will provide the funds needed to replace a structure either partially or completely destroyed by fire or other causes. Without it, such a loss could mean financial disaster. A knowledgeable construction lender requires coverage in an amount equal to 100 percent of total cost.

Economic Feasibility

Too much emphasis cannot be placed on the principle that a construction loan is supported by real estate and not by a long-term lender's commitment. As a result, the construction lender should appraise the real estate personally and be familiar with all the considerations which were evaluated to determine the value of the project upon completion.

Rules of thumb such as value per square foot or per unit are fine for a cursory review of a loan submission. However, a prudent lender should prepare an individual estimate of income and expenses and capitalize the resulting net income into value. The lender cannot forget that the single most important step in an appraisal is the determination of a capitalization rate. No other estimate in the appraisal will have the same dramatic effect on value as a change in the rate applied to the projected income.

A tenant essential to the economic success of the project should be evaluated as if it, too, were one of the borrowers. If the credit of a tenant is important to a long-term lender, why should it not be important to a construction lender? If there is a problem, there is a good chance that the construction lender will become the long-term lender by default.

Since this is one of the realities of construction lending, all proposed real estate projects should be analyzed as to their mortgage-ability. These questions should always be asked: Can this project support a mortgage in an amount-equal to the construction loan at the present rate and terms? Is the project capable of carrying the long-term mortgage which has been committed?

If the answer is no to either question, a review of the requested loan amount is necessary. A useful analysis in determining lender exposure to the successful marketing of the completed project is a study of the occupancy levels needed to carry various amounts of debt and the rental range within which the proposed debt can be serviced.

The last few years have shown lenders how drastically the money market can change in a matter of months. A construction lender tries to limit this exposure by requiring a long-term mortgage takeout prior to committing a construction loan.

The long-term commitment is an added complexity and requires careful analysis. Long-term lenders' commitments are seldom firm commitments. They usually contain provisions for the funding of a floor or minimum amount upon completion of construction, and a ceiling or contingent amount upon the achievement of a specified rent roll. Ideally, the construction loan should be equal to the floor amount.

However, this may not always be practical. As a result, the construction lender has to evaluate the property's ability to achieve the specified rent roll in a given period of time. Most long-term commitments include a timing limit for funding of the floor and ceiling amounts. The construction lender must assure himself that there is ample time within which to complete construction and rent the project.

Some long-term commitments are only standby commitments and are not expected to be funded unless there are difficulties in finding long-term monies elsewhere. Even then, the long-term lender may not wish to fund. Every construction lender should study the possible escape clauses in a long-term commitment and try to provide for them in the structuring of the construction loan.

Recently, construction lenders have found that some of the long-term lenders may lack the ability to fund. It is necessary in the underwriting process to develop some information on the financial strength and health of the long-term lender. Some lenders are known in the industry as "fee takers," with no intention of ever funding a commitment.

Construction lending is real estate lending. Consequently, the construction lender should be aware that the primary security is the real estate to be developed and that the development has to be completed in order for the loan to be repaid. Few real estate borrowers can repay a construction loan from the assets listed in their financial statements. The borrower's professional and financial capabilities are a key element in the overall loan and should be thoroughly evaluated before a loan commitment is issued.

A construction lender who is aware of aware of the areas in which risk exposure exists and can adequately provide for them will be able to deal with the demands made of him when the activity of the market increases and to formulate those changes which will be required in future construction lending policies.