After years of little to no construction lending, construction lending is starting to make a comeback. It’s now becoming a more frequent a topic of our loan review engagements. That’s why it’s time to dust off the construction lending policy!
Construction lending can be an opportunity for a community financial institution to build relationships with local developers, earn interest and fee income, and help the local economy grow. However, there are certain risks associated with this segment of lending which need to be addressed and fully understood before the loan is put in place.
I always found it interesting that there are more financing sources available when a construction or development project is completed. It makes sense, however, considering the additional risk inherent in the construction process. Everything from project costs to financial performance is based on projections. Sure there are some relatively predictable market data available, such as the going rate for comparable square footage or apartment unit’s rental rates, but items such as cost overruns, market changes, and other general assumptions naturally create an elevated risk. It’s almost unfair to the financial institution that provided the construction financing, but once the project is complete, competition is fierce as several of the unknown variables become known. At this point, the risk profile is significantly reduced.
It’s important for financial institutions to understand some of best practices as it relates to construction lending. Keep in mind that construction projects vary in complexity and risk profile. Your financial institution should apply a prudent level of structure and analysis to understand and mitigate the risks going into the relationship.
On the front end, the analysis your financial institution performs should depend on the complexity of the construction project. Some areas to include:
- Experience of the owner/developer: Discuss similar construction projects the owner has previously developed and understand other projects the developer is currently involved in.
- Cash flow analysis: A proforma cash flow is critical, as is a stress test to determine the amount of variance from plan the property can sustain — and what that does to the borrower’s ability to support debt service. Make sure a market rate vacancy level is included in the proforma cash flow.
- Global cash flow: Understanding the global cash flow is important in the event that the new construction does not perform at the level or within the timeline projected. At that point, understanding the support your guarantor can provide going into the transaction is important.
- Market information: This should include a discussion of the current market including capacity, occupancy trends, and demographics which could impact the project. An example would include additional multi-family projects coming on line in the next six months.
- Tenants: For commercial projects, know the tenants and what factors could impact the tenant’s ability to fulfill the lease requirements. Understand the tenant’s industry and include a tenant profile. A start-up first-time entrepreneur is a different risk profile from a well-established, well-known business signing a long-term lease.
Monitoring requirements will be different based on the developer and specific project. Generally, we recommend at least the following:
- Commercial properties: Annual rent roll, tax returns, and copies of leases (at least from the key tenants).
- Residential properties: Annual tax return and monthly statements until the property is stabilized.
- Mixed-use properties: Annual rent roll on the commercial areas and monthly statements until the property is stabilized, along with copies of key tenant leases.
A risk management firm talking about return on investment? Absolutely! You need to be properly compensated for the risk you’re taking. I understand the competitive nature of lending and the need in certain cases to lead with a strong loan terms. However, keep in mind the additional work involved with a construction project, and the additional risk we’ve discussed here. Not only is it important to cover the cost of the draws and additional management of the construction process, but an up-front fee also can account for the additional work needed in managing such a loan. In the past, financial institutions have essentially broken even on the construction lending component, only to make it up on the permanent financing. Unfortunately, there’s a chance the financial institution that funded the construction loan could be paid off quickly once the property is finalized. Therefore, make sure you earn your return during the construction phase as well.
In general, a structure should force the borrower’s cash to be injected on the front end of the property, provide sufficient time for the construction to be completed, and have a procedure for addressing things that will most certainly come up during the process. Here are a few items to consider:
- Interest-only periods are a standard part of construction lending and, as a general rule, should extend 60-90 days beyond the projected end of the construction project.
- Get cash in on the front end. Have the borrower fund a deposit account from which draws will be pulled until the loan is funded.
- If you have a general contractor who wants to use the general contractor fee as equity: 1) Limit the fee to market standards (gone are the days where contractors received 15% – 20% of a construction project). 2) Get cash up front and reimburse the contractor as the project moves toward completion.
- Maturity date of permanent financing should not exceed lease expiration dates for commercial properties.
- Advance rates and collateral analysis should be based on “when complete” value, not “when stabilized” value. Use “when stabilized” once the property is performing as the “when stabilized” assumptions noted in the appraisal.
- Clearly document the process for your borrower on how draws will be processed. It’s important to include a general sense of turnaround time.
- Require independent site inspections to monitor the construction process.
- Title companies should fund the draws, and require lien waivers.
- A completion certificate should be obtained once the project is complete. In most cases, the appraiser who completed the original appraisal will be expecting this request. Make sure it’s part of the appraiser engagement letter.
- Have a process for overages, including who would be responsible to cover them (borrower, financial institution or a combination).
- Include a cost overage in the construction budget, which could amount to 10% of the project budget.
- Require strong internal tracking of the actual budget to projections, and require multiple sign-offs when processing draws. A typical process would include the draw being submitted to the financial institution, then approved by the lender, reviewed and approved by credit administration and funded through the title company.
A financial institution can mitigate a significant amount of the additional risk in a construction project when done properly. At the same time, construction loans can be good source of loan growth and relationship building with local developers.
Peter Nugent, Director and founder of Enlighten Financial, a specialized consulting firm that focuses on providing loan review and risk management services to community banks and credit unions. Peter guides the company’s service offerings, which include in-depth loan reviews, commercial and personal underwriting/analysis, internal process improvement and workout services. To talk to Peter directly, please call: (920) 354-6797.