Managing Construction Lending Risk

By Bill Beardsley

Nothing feels better as a lender than being part of something new. There is something pretty amazing about being part of creating something you can see, something important. There is no doubt construction lending provides meaningful impact on communities, business and families.  But, construction lending also has the reputation of being high risk, and who wants or needs “high risk” at this stage of the economy?  On the other hand, NCUA eliminated their long-standing limit on construction lending and reduced prescriptive rules related to loan to cost and loan to value.  That message is clear—do as much construction lending as you can prudently do–but do it right. We’re seeing a lot of construction right now, as are others from what I hear.  When is a lot too much?  Properly administered that answer is not a specific number, or percent of capital, but rather a function of your ability to manage risks.  

So let’s look closer. Where are the risks of this type of lending, and how can Credit Unions manage those risks so they can play an increasing role in building their communities? 

Concentration Risk: The biggest risk I have personally seen in financing construction and development projects has nothing to do with construction activity itself.  Concentration risk means you are doing too much of one thing.  In most cases, this means you are doing too much of one type of project. For example, banks were absolutely hammered during the Great Recession due to excessive land development or condo financing. Bad memories have a tendency to be suppressed in good times.   The new home market is volatile and the reality is that in a contracting economy an unsold lot or condo unit can plummet in value.  And rarely does it go bad at the end of a project. Rather, you might suffer the loss of value on many lots or units.  When you are doing this type of financing, it requires higher levels of expertise, and borrowers with the strength and liquidity to keep things afloat in the bad times. My advice—avoid “for sale” land development financing altogether, unless you truly have an exceptional set of circumstances and capabilities.  For non-land development, just keep an eye on exposures at the borrower, contractor and property type level.  With proper diversification there is no need to adopt restrictive policy limits, as there is no inherent risk that would spread from one project to another.  What is most important to understand and manage is your own ability to manage the workflow.  

Contractor Risk:Even your best borrower and most prudently structured loan can go sideways with a bad contractor. Good economies can mask bad performers, but all gets revealed when the tide turns. So always get references, preferably from other lenders, when dealing with unknown contractors. When possible, obtain financial statements for the contractor to ensure they have the funds to keep a project lien free in between draws.  Construction workers often want to be paid every week or two, and suppliers often want up front deposits or even payment in full upon delivery.  Construction draws, however, typically take place every four to six weeks.  These timing issues need to be managed by the contractor. Also make sure the contractor understands and is willing and able to give you the documentation you need and time to process it at each draw. Be particularly concerned with “owner-builders” unless they are very experienced.  Lender references are a must. 

Credit Risk:  With all the attention on the contractor, don’t forget to fully underwrite the borrower and its principals.  Consider obtaining background investigations on principals involved in material construction projects.  It is very common for real estate owners/developers to have some legal issues due to the nature of their business, but be particularly concerned about legal issues that involve other lenders, fraud, etc. 

Speculation/Tenant Risk:  While relevant in both the Concentration Risk and Credit Risk sections above, be sure to fully understand the quality of tenants being proposed for a new investment real estate project.  All too often developers will play up the name of a national tenant, when in fact the tenant could be a start-up franchisee.  Start-ups look good on paper but might not get off the ground as expected and can cause issues post construction, or even during if they are responsible for paying for tenant build outs. On a related note, nothing is more important to an investment real estate property than the content detail of leases, which may include very specific requirements that relate to construction and delivery.  Be sure to review the entire lease and discuss with the borrower and contractor the required deliverables.  

Budget Risk:  Beware of the potential for cash strapped borrowers to under-estimate the total project cost so that their up-front equity can be kept within their means. When cost overruns happen, you are often in no position to refuse an increase. Always have a professional third-party budget review performed, preferably by an architect to help authenticate project costs. And, insist on including a contingency line item of 5%-10% to provide some extra cushion. By doing this, you increase the borrower’s required equity, which you can opt to refund if the project comes in as budgeted.  Most importantly, always require all the borrower’s equity in cash up front.  The amount of availability on the construction loan must exceed the amount of funds needed to complete the project at all times. 

Documentation Risk:  Construction lending has very standardized documents. Use them!  Choose a title company experienced in construction and make sure very clear procedures are established and that the mortgage is placed before the first shovel hits the ground.  Be cautious when contractors insist on using a specific title company, unless you also know them.  A very well qualified, and by the book, title company is a line of defense for lenders and property owners.  As noted by regulations, site inspections by qualified parties representing the lender should be conducted prior to each draw and always obtain title insurance endorsements with each draw. Lastly, be sure to verify that the municipality has actually approved the construction plan and issued permits before construction begins. 

Liability Risk:  A lot can go wrong during construction, including accidental injury, theft, etc. Verify “builder’s risk” insurance coverage and fully understand the project’s security concerns.  Discuss the need for fencing, security guards or cameras when in areas prone to crime. 

Timing Risk:  Be particularly diligent in understanding the expected construction timeline and build in a little extra cushion. The construction trades have never been busier, and your project will stall if the contractor doesn’t have the ability to get sub-contractors on the job when needed.  An extended construction delay can have huge budget impacts or can cause the project to miss an important delivery date expected by a tenant or seasonal operating window and cause operating cash flow deficits long after construction is complete. 

Construction lending is an important part of business lending, and should be part of every Credit Union’s tool box, but only when there are qualified resources available in the Credit Union or through a third party such as a CUSO.  When done right, the benefits of a properly managed construction program are great and those benefits are shared between lenders, business borrowers, their employees and the communities that enjoy the project being constructed.