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Fundamentals of construction lending

Kate Stoneburner
January 3, 2023
Read Time: 0 min

Sound construction loan principles and processes

Start with the basics to build a successful construction loan operation at your financial institution.

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

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Introduction

Construction lending from the ground up

Construction loans are short-term loans funded in increments over the project’s construction. The borrower pays interest only on the outstanding balance, so interest charges grow as the project progresses. But construction loans are also unique because they are three-party agreements between borrowers, banks, and construction contractors.

During a recent construction lending webinar, lending and credit risk expert Dev Strischek of Devon Risk Advisory Group outlined the keys to construction loan success. Strischek included the following information, which can help lenders avoid risk before the project begins—by planning ahead at the closing table.

Allocation best practices

Budgeting, equity, and advancement of funds

Lenders view construction loans as short-term, high-risk, high-yielding investments. They must follow strict procedures to mitigate risk and ensure a good relationship between the outstanding loan balance and the collateral value.

One of the keys to successful construction lending on the financial institution side is never to advance money to a project until after progress has been validated—and never fully fund a project ahead of its completion.

Construction lenders will typically advance funds for these purposes:

  • Land acquisition costs
  • Engineer and architect fees
  • Survey costs
  • Title insurance costs
  • Legal fees

Contractors submit monthly progress payment requests as materials are purchased and construction proceeds. These requests outline the work completed to date, the construction funds previously received, and the new amount being requested. One of the best ways for banks to keep track of draw requests is to invest in construction loan management software, which is proven to help mitigate risk associated with inefficient loan monitoring and decrease the probability of default.

Another critical component for a successful construction loan is an organized budget, which should be broken down into hard and soft costs.

Hard costs include the physical elements of the project, such as:

  • Land
  • Site work
  • Equipment

 Soft costs include the pre-construction costs, such as:

  • Plans
  • Permits
  • Engineering tests
  • Bank or legal fees

Budgets also should include a contingency that will act as a reserve to cover unexpected costs, such as rising prices or weather delays. A 10% budget contingency is the rule of thumb to cover unpredictable factors, but one size does not fit all. The contingency should be adjusted for the current environment, so consider poor weather, supply chain issues, and other market factors that may make a 15-20% contingency more prudent.

The loan-to-value (LTV) ratio, or the relative difference between the loan amount and the project’s market value, will determine what borrowers need to provide in equity. The lower the LTV, the less risky the project is for your financial institution. If your bank policy allows an LTV of up to 80%, then borrowers’ equity will be 20%.

This doesn’t mean that borrowers need to provide equity in cash. Unencumbered land counts as equity, as do valid project costs already paid before the loan is made. But whatever remaining balance there is after accounting for those costs must be paid by the borrower at the closing table.

Borrowers

Contracts and types of borrowers

The construction contract is primarily an agreement between a general contractor and the borrowing client. Many lenders use the well-established American Institute of Architects contract as a starting point. Remember that a contract should be specific to the project’s jurisdiction. It should also:

  • Be written for a fixed payment sum
  • Provide for the lender to hold retention
  • Require the lender’s approval of any modification of contract value
  • Not allow for requirements for an advanced payment, “mobilization” fees, or any other form of prepayment to the contractor

Strischek identified three types of borrowers to help lenders make loan decisions: Real estate developer-investor (REDI) borrowers, Co-REDI borrowers, and owner-occupied borrowers.

  • REDI borrowers are actual professional real estate developers. With this type of borrower, the sole source of income is the sale or lease of the property.
  • Co-REDI borrowers are slightly more amateur than real estate professionals but still rely on the sale or lease of property to repay their loan. For example, a law firm that has decided to build a new office building rents out an existing space so the rent can serve as the new building’s loan repayment.
  • Owner-occupied borrowers’ repayment comes from the business operation. An owner-occupied borrower might be a wholesaler who has decided he needs to double his warehouse. Payment for the renovation loan will come from the operation of that warehouse, not the sale or leasing of the property.

On the one hand, owner-occupied construction projects are appealing because a regular paycheck takes care of the loan rather than the eventual sale or lease of the new build. But if the business needs help during the project, it can become a risk to your institution. Owner-occupied project properties can also be specialized (like an ice rink or bowling alley). This makes them less valuable collateral in the event of an issue.

When it comes to the number of borrowers on a project, the fewer, the better. Partnerships can be risky because of the potential for conflict. It’s best to avoid the complicated legal/ownership structures that often accompany partnerships and to avoid co-borrowers or a group of borrowers because conflict is more likely to slow down the loan process.

Red flags

Developers, insurance, and material suppliers: Red flags and what to look for

When it comes to the developer, lenders should seek out a person with a good track record for building in the project-specific field. If the borrower is building a warehouse, it would be best not to hire a developer who has only built office buildings and vice versa. The ideal developer is also familiar with the market area and knows their way around the territory and suppliers available.

There are far more construction contractors in the U.S. than construction material suppliers, meaning that suppliers can afford to be pickier about the projects they work on. There are only so many gravel and asphalt suppliers and three leading steel suppliers in the country. The advantage is usually to the supplier, and if the supplier has a low opinion of the developer or borrower, it should give banks and credit unions pause before closing a loan.

A similar principle applies to insuring the project. If a contractor’s insurance agent is having trouble finding bonding for the contractor, it might simply mean that the job is very large and a more significant bond is necessary than usual. But it could also mean that insurers are wary of or unwilling to work with your contractor, which could be a red flag.

 

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Mitigating risk

Repayment terms and collateral

Repayment terms must be long enough for the borrower to complete the project and get it sold or leased. Every bank has a different risk tolerance regarding the life of a loan, but not many financial institutions are willing to offer construction loans for more than five years. Depending on a bank’s asset/liability priorities, it may also be keeping a short portfolio—especially since adopting the current expected credit loss standard, or CECL.

Under CECL, the loan loss reserve will need to be higher for banks specializing in longer-term loans because those banks will need to project the loss over more extended periods. It's one thing to project a loss on a one-year loan, but a five, ten, or 30-year loan is a different story.

To mitigate risk, lenders can take steps to ensure that the collateral of a not-yet-complete building is adequately evaluated.

  1. Lenders should be in the first mortgage lien position. This means work should only be done on the project site after the mortgage is recorded. Work includes footings being staked out, materials or equipment being dropped off at the site, and clearing brush or hauling debris from the site.
  2. Lenders should require all architectural plans, drawings, and specs, including all studies, site tests, and permits. They should have access to the construction contract, including all rights, to ensure nothing falls through the cracks.
  3. Lenders should require at least one survey and include it as part of appraisal and title work before closing. The survey should be accepted without any encroachments ahead of closing. A second survey should be required after the foundation is completed to ensure correct placement. And a final survey should be conducted to provide a record of all completed site improvements

Standards & deviations

Conditions, covenants, and policy exceptions

All deals must be structured to ensure that the borrower repays in full, on time, and as agreed. The “as agreed” component means that the borrower has abided by the conditions and covenants set out by the lender before closing.

Conditions are the standards we expect the borrower to meet at the loan's inception. Covenants govern the borrower's activity or actions over the life of the loan.

The following are examples of common conditions and covenants in a construction loan scenario:

Conditions—must be compliant at the loan’s inception.

  • Property maintained
  • Taxes paid, no judgments or liens
  • Insurance in place
  • Clean title, satisfactory survey
  • Satisfactory appraisal &environmental audit

Covenants—must be compliant over the life of the loan

  • Maximum LTV
  • Maximum LTC
  • Minimum equity
  • Minimum DSC
  • Minimum debt yield
  • Pre-sales/pre-leases

These conditions and covenants act as guardrails to ensure that your customer or borrower doesn't run off the road to repayment.

Policy exceptions

A quick look at a financial institution’s policy exceptions can reveal whether the loans they have on the books generally comply with policy and how well the bank handles risk.

Regulatory agencies keep a close eye on a bank’s policy exceptions. When policy exceptions begin to increase, it suggests that, for whatever reason, the bank is approving loans that are more at variance with its policy. Why would that be?

Perhaps, for example, a lender has decided that the risk attached to a high LTV has been mitigated in some way, but the bank still must track the exception knowing that the loan is a little outside the box. Usually, these policy exceptions come along when loan review staff and workout staff have years of experience at the bank.

The following is a list of common trackable policy exceptions (TPEs) that apply in construction loan and commercial real estate loan scenarios.

  • LTV ratio greater than 80%
  • appraisal
  • environmental audit
  • spec purpose
  • pre-leasing/pre-sales
  • min occupancy rate
  • min release prices
  • maximum LTC
  • minimum equity

If these policy exception loans frequently spend time as a problem loan before being repaid, it is time to reassess your loan policy to avoid unnecessary risk.

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About the Author

Kate Stoneburner

Content Marketing Manager
Kate Stoneburner is a Content Marketing Manager at Abrigo, where she works with industry thought leaders to create digital content that helps financial institutions better serve their customers. Before joining Abrigo, Kate managed social media and produced articles for Campbell University’s quarterly magazine and other university content initiatives. She earned

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Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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