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Study: Construction loan monitoring decreases loan defaults

Mary Ellen Biery
September 15, 2022
Read Time: 0 min

Monitoring construction loans improves outcomes, study finds.

Researchers find construction loans with more on-site inspections are less likely to default, suggesting that loan monitoring adds value to lenders.

You might also like this webinar, "How to manage a high-performing construction loan portfolio."


On-site inspections

Bank monitoring in construction lending

More construction loan monitoring ultimately decreases loan default, according to a new FDIC Center for Financial Research working paper.

The paper, “Bank Monitoring with On-Site Inspections," will be presented later this month at the Community Banking in the 21st Century Research and Policy Conference. It claims to be the first empirical study of bank monitoring within non-syndicated loans to test long-held theories that banks’ ability to monitor borrowers is a key advantage.

While it doesn't necessarily reflect the views of the FDIC, the paper includes preliminary findings from research by FDIC staff and an FDIC Visiting Scholar. It is based on 30,000 multiple-draw construction loans as well as examinations of:

  • The frequency of loan monitoring by the bank via staff or third-party on-site inspections
  • The contents of the inspection reports
  • The borrowers’ actions over the life of the loan.

“We provide a comprehensive analysis of the determinants of construction default, the first study of its kind, as a preamble to analyzing the incremental effect of monitoring,” authors Amanda Rae Heitz, a Visiting Scholar from Tulane University, FDIC Senior Financial Economist Christopher Martin, and FDIC Senior Financial Economist Alexander Ufier wrote.

“After implementing an instrumental variable framework and controlling for relevant determinants, we find that loans with more on-site inspections are less likely to default, suggesting that, in line with theoretical predictions, monitoring ultimately improves loan outcomes and adds value to banks.”

The researchers controlled for a broad range of project, borrower, and loan characteristics the bank could choose in making the loan and setting terms, including the draw schedule, to best measure the marginal effect of more inspections on default. They found that increasing inspections from two in a 100-day period that a loan was active to three inspections in a 100-day period would lower the probability of default by 3.63 percentage points.

“As the default probability is approximately 5 percent for these loans, this is a meaningful improvement in default probability,” said the authors, who previously circulated the paper under the title, “Bank Monitoring in Construction Lending.”

The researchers also found that banks are more likely to deny draw requests when projects have negative inspection reports, supporting the idea that information collected during monitoring is important to banks’ decision-making.

In addition, researchers showed that construction loan monitoring is less frequent for loans where the bank has a prior relationship with either the borrower or the project contractor. This suggests that banks may be “transferring information across projects,” the paper’s authors wrote, adding that reduced monitoring costs might be a resulting benefit.

Managing construction loans can be complex and time-consuming, especially if financial institutions rely on manual processes and spreadsheets to track budgets, inspections, due dates, and draw information. Automating construction loan management makes processes more efficient across the board so that financial institutions can monitor both isolated and concentrated exposures in the portfolio.

CRE loans up

Bank construction lending: $403 billion

Commercial real estate loans have increased as a share of bank balance sheets over the last nearly 40 years, with the biggest proportional increase occurring among small banks, the authors wrote, citing Call Report data.

As of the fourth quarter of 2021, banks had total construction lending of $403 billion, the study said. It also noted that construction lending was one of the primary contributors to bank failures during the financial crisis.

The research report is timely, considering supply-chain issues that have increased the risk of defaults on some construction loans. Financial institutions with construction loan portfolios understand that managing complicated budgets, draw requests, and risk management of construction loan monitoring is especially important in the current environment of inflationary project costs and rising loan-funding costs.

The traditional bank system of construction loan monitoring—manually tracking project budgets in spreadsheets and collecting inspection reports via email or paper files housed in multiple locations—can make responding to draw requests and updating costs a complicated job. Construction loan management software that automates much of the process in a single platform can streamline the process. It can alert inspectors automatically when site visits are needed and alert lending staff when inspection reports have been completed, reducing the risk of overfunding projects while increasing draw income.

Indeed, the FDIC authors noted that commercial real estate lending (CRE) is inherently risky, saying researchers have widely considered construction and land development loans as the riskiest sub-category of CRE lending.

“Banks may remain dominant in these loan categories because of their comparative advantage in managing complex lending relationships, such as through monitoring loans,” they wrote.

However, researchers have struggled to test many theoretical models of monitoring and whether banks have superior monitoring capabilities because direct evidence of monitoring is rarely observable in commercially available databases, the authors said.

Download this checklist for construction lending tips: "10 Ways construction loan monitoring software saves time."

Study features

Construction loan monitoring: on-site inspections

For this study, FDIC researchers used a proprietary, transaction-level set of construction loans (mostly to smaller builders and homeowners) originated over 10 years from a large bank that served a broad customer base in many markets. The unidentified bank failed during the financial crisis, primarily due to the performance of its primary business: single-family home residential lending.

The average loan in the study sample had a term of nearly 14 months, nearly 13 draw attempts, 8.15 on-site inspections, and an initial inspection occurring 3 months after origination. The average project had nearly 59 budgeted line items.

Researchers studied the timing and frequency of on-site inspections by bank staff or third-party inspectors, the contents of the reports, and how the banks used the information in the reports.

They found that larger loans are monitored more. They also found that lower interest-rate spreads at origination and lower fees are significantly associated with more monitoring. Longer-term loans were subject to less intense monitoring.

Loans determined to be speculative (built to be sold later in the general market) were inspected for the first time 28% sooner than other loans. More complicated projects, as measured by those having more budget line items, were inspected more frequently.

“These results show that the bank monitored riskier loans more, potentially because the information it was extracting on these loans was valuable and the bank was attempting to prevent loan default,” researchers wrote.

Looking more closely at the determinants of default rates for the construction loan portfolio, the study’s regression results indicated that loans with longer maturities and greater fees, as well as loans to lower quality borrowers (such as those with lower credit scores) were more likely to default. “Loans made to owners building their own homes are less likely to default, potentially because owners have the intent to occupy their dream home,” the authors wrote.

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About the Author

Mary Ellen Biery

Senior Strategist & Content Manager
Mary Ellen Biery is Senior Strategist & Content Manager at Abrigo, where she works with advisors and other experts to develop whitepapers, original research, and other resources that help financial institutions drive growth and manage risk. A former equities reporter for Dow Jones Newswires whose work has been published in

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