Return to Table of Contents
Chapter 4: Construction Lending
Beautiful credit! The foundation of modern society. Who shall say that this is not the golden age of mutual trust, of unlimited reliance upon human promises? That is a peculiar condition of society which enables a whole nation to instantly recognize point and meaning in the familiar newspaper anecdote, which puts into the mouth of a distinguished speculator in lands and mines this remark:- "I wasn't worth a cent two years ago, and now I owe two millions of dollars."-Mark Twain, The Gilded Age
Construction lending presents particular problems to lenders in underwriting, servicing and legal documentation.
When underwriting a property the first step is usually to look at its operating history. The value of the property suggested by its prior performance will generally govern the terms of the loan you would be willing to offer its owner. You might be willing to lend more if you were strongly convinced that new management could make the property more profitable, or if market conditions had changed enough to convince you the prior performance would almost certainly be exceeded. But, in general, there is little reason to assume that a property's performance will suddenly improve over its history.
In construction lending, an underwriter does not have access to a financial history of the project, so the valuation of the property must be based entirely on pro forma assumptions. Underwriting a new project is therefore much more dependent upon a comparison with the comparable properties. In particular, you want to pay close attention to the instantaneous leasing activity. Just because the thirty story office tower across the street is performing perfectly, since it locked all its tenants into leases five years ago during the last office space crunch, doesn't mean that your new building will be able to do as well in today's overbuilt market. An important consideration in construction lending is pre-leasing or pre-sale(s) of the project being built. If a project is not pre-leased or pre-sold, it is referred to as spec (for speculative) construction.
There is another obvious risk in construction lending: that the building will not get built. In order to address this risk the underwriting must not simply focus on the economics of the completed project, but also the competency of the developer, architect, engineers, general contractor, sub-contractors, and others involved in the construction process. In truth, it is rare to look so deeply into the project's workforce. Generally, a close look at the developer and the general contractor is sufficient. The assumption is that if those two are competent and experienced, they will hire others who can competently do their jobs.
Evaluation of the developer and the contractor is of course based on their prior performance. Have they successfully developed/built similar properties in the past? I mentioned in the discussion of the borrower/guarantor of the loan that it is sometimes difficult to determine what wealth a guarantor must have to add a real measure of comfort to the loan. I think it is safe to say that however much financial strength you might require for making a regular loan, for a construction loan of equivalent size you will want a borrower of greater financial strength. And of greater real estate experience as well. More financial strength is needed because of the very real dangers of cost overruns and construction and leasing delays. More experience is needed because of the added complexity of running a construction project and leasing up a new building over managing an existing building.
A reliable general contractor is good insurance against cost overruns. A reputable contractor will not underbid a project just to get the business. Underbidding a project and then asking to be paid more once underway is generally impossible in any case because of guaranteed maximum price contracts (GMP contracts). A contractor gives the developer a GMP contract after a careful review of the architect's plans and specifications. After this price is agreed upon, the contractor must deliver the building for this price. The disadvantage of this from the developer's point of view is that the contractor will sometimes bid a project cautiously (i.e. higher than what he expects it to cost) since he knows no matter what he has to build it for the agreed price.
Naturally, there is an exception: the change order. Change orders can come about for a variety of reasons, but in general they are caused by a change in the plans that occurs after the construction contract has been signed. If the plans have changed, the contractor can of course demand to be paid more for his work. Generally extras of this kind will be quite expensive relative to the cost of the rest of the building, since it is unlikely that the developer will be able to have competitive bidding done for the change orders. Change orders can also be requested by the contractor. How can that happen? The contractor can argue that the plans were too vague when he bid the job and signed the contract. The contractor thought the plans allowed him to use cheaper materials than the developer or architect is now insisting on, for instance.
One of the primary questions to ask yourself while underwriting a contractor is if the firm is big enough to do the job. If a contractor has never worked a job of comparable size, he might not have the management skill, access to manpower, relationships with materials suppliers, or the capital to keep the project moving when his payments are delayed. You also want to be sure that a contractor is appropriate for the particular job. Just because he did a great job on all those multi-million dollar self storage facilities, doesn't make him the right man for building your luxury, high-rise residences.
The same question should of course be asked about the developer. Has he built projects of the same type and magnitude? Additionally ask: Does he understand the market that he is entering? Can he support the cash needs of the project if there are leasing problems and you have disbursed as much money from your loan as you are willing to? (Actually, though the bank makes every effort to put a hard cap on how much money it will disburse for the construction of a particular project, if there are cost overruns in all likelihood the bank will be forced to raise its loan amount. What choice will you have? Even if you foreclose and own the property, you probably won't have much luck selling a half-built hotel. More on this problem later.)
Documentation for a construction loan is also more complicated than a loan on an operating property. The first difference is that in addition to all the regular documents there is also something called a construction loan agreement. This is a fifty page document that restates many of the terms that are in the note and the mortgage, but also contains a lot of information about how disbursements are made to the developer. There is also something called a construction escrow agreement, which is fun since it's a tripartite agreement, the three parties being the bank, the borrower, and the construction escrow agent, namely the title company. The one nice thing about closing a construction loan (compared with a regular loan) is that you frequently have a "dry" closing, where no money is disbursed. That makes the whole thing much more relaxed. No money is disbursed because before the bank pays for anything the borrower must make his equity contribution.
Equity Contribution/Loan In Balance
How much money the borrower puts into the project is actually a mildly tricky issue when dealing with construction loans. When buying a property the price is fixed and the bank and the borrower can agree exactly who will contribute how much. Then on the day of the closing, those contributions are made simultaneously, and the transaction closes. When building a new building the payments are spread out over time and the final price is unknown until the building is completed. Therefore a more complicated recipe is required to insure the loan does not exceed the amount the bank is willing to lend.
The first rule is that the borrower's money (called the "equity investment") always goes in first. Of course the first rule is always the first to be broken. When the rule is broken the bank calls it "deferred equity". Deferred equity is tricky for the following reason: once the bank has disbursed the money to begin construction of the building and it is time for the borrower to put his money in he may be unable to or he may simply refuse. Then the bank will have two choices: either complete the building itself or try to foreclose and sell a half done project. The first option is undesirable since the bank is then exposed to much greater risk than it was supposed to be. The second option is even worse since the market for buildings without walls is just terrible.
The second rule is that the borrower must keep the loan in balance. What that means is that the sources for the project (the equity investment plus the bank loan) must always equal or exceed the remaining uses for the project (the costs of construction and development). The bank goes through a great deal of trouble and time to make sure that the loan is in balance throughout the loan. Although what to do when the loan goes out of balance is a tricky problem. Imagine the building is half done and the bank has begun disbursements from its loan. Suddenly, for whatever reason, the project is going to cost a million more to finish than expected. Once again, if the borrower is unwilling or unable to fund the excess costs the bank is likely to be obliged to.
The bank's favorite kind of equity contribution is the non-deferred cash variety. Cash is real, cash is easy to value, cash means the borrower really believes in the project. Often, however, the borrower will contribute land equity to the deal. This is not a problem as long as the land was bought in the last year or so. Then the borrower and the bank will generally agree to value the land at costs. If the borrower has owned the land for years the bank and the borrower may have a disagreement about how much the land is worth, and therefore how much additional cash equity the borrower needs to put in. This argument can sometimes be solved by putting the question into the hands of an appraiser.
Then there is "in-kind equity". This is the name given to the labor a borrower puts into the project. For instance, if the project budget has a line item for developer's fee, the borrower might ask the bank to treat that as an equity contribution. A $10 million project might have a $500M developers fee, and the borrower may say to the bank, "I will not draw any money against that line item from your loan and I will only put $2 million in cash into the project. But, taken together you will treat those as your required 25% equity contribution." Fairly bogus.
There are tricks to keeping the loan in balance too. Many developers will put a line item in their sources called something like "rental income during construction". Well, that's great if the borrower can actually lease some space in the building before there are walls and start collecting rents to offset the construction costs. But of course, if they are unable to do so, the project will be thrown out of balance. Collecting income during construction is not always as entirely unrealistic as it may sound at first, however. For instance, during a condominium conversion project a developer may well be able to use the proceeds from the sales of the first units in the building to finance the renovation of the remaining units. In general, though, the bank is very against playing this game.
I cannot refrain from making a quick editorial comment here. The template construction commitment letter contains a section headed "Loan In Balance." The first sentence of which reads "The Loan shall be deemed to be 'Out of Balance'..." Naturally, I have rewritten it so that the commitment letters I work on read "The Bank will deem the Construction Loan 'In Balance'..." Despite my way being superior in at least three ways (1. The text matches the heading. 2. It makes a positive statement. 3. The sentence is written in the active voice.) the reactionary forces in power have resisted changing the template to my version. This job can be extremely frustrating.
Remember from the discussion of mortgages and title insurance that one of the things that can prime a mortgage is a mechanic's lien. Since mechanics' liens arise when a builder adds value to a property the potential for incurring mechanics' liens during construction is enormous. The question for the bank is, how can we disburse money to the borrower, and still retain a valid first mortgage lien? The answer to the problem is that the bank collects lien waivers from the contractor and the subs when it disburses the money.
That solves one problem, but another one remains. The valid first mortgage lien must remain insured. At the closing the bank receives a title insurance policy, but it doesn't insure the bank against future mechanics' liens. The policy sets out the amount of the insurance (the amount disbursed at the closing) and the effective date of the policy (the date of the closing). The bank needs the title insurer to insure against defects that occur after the date of the closing and for amounts disbursed after the closing. So, in fact, the bank does not collect the lien waivers, the title company does. When a developer wants to pay his bills he actually sends his construction draw request to both the bank and the title company. The bank sends the money to the title company to disburse directly to the contractor and subs. When the bank sends over the money, it sends the title company directions (escrow trust instructions) not to disburse the funds until it is willing to insure the bank for the amount of the money disbursed and to change the date of the policy to the date of the disbursement. The title insurer does this by giving the bank a title endorsement called a "date-down endorsement".
Now that you have the basic idea, let's go through a construction draw step by step. It starts when the borrower gets a bill from the general contractor. A bill should come in the form of a sworn contractor's statement saying that the work being billed for is complete and in place. The borrower then puts together a sworn owner's statement, including the contractor's statement and adding any additional bills for soft costs. (What's a soft cost? Construction projects generally have three types of costs: land acquisition, hard, and soft. Land acquisition is presumably self explanatory. Hard costs are for the materials and the workers, everything you can see. Soft costs are for everything else: architects and engineers, bank fees and interest, soil and environmental testing, leasing commissions, developer's fees, etc.) The developer sends these two documents, any required supporting documentation, and all the appropriate lien waivers to the title company and the bank. (And also to the bank's consulting architect if there is one.)
The consultant, and sometimes a representative from the bank, visits the site and confirms that the contractor's statement correctly reflects the work done and the materials bought. The consultant then prepares a report for the bank on the progress of the project. The report should assure the bank that the work that has been done and the amount being billed for are proportionate.
The bank then analyses the owner's statement. The most important question the bank is concerned with is whether the loan is in balance. This can be difficult as we are somewhat dependent on the developer being honest with us about what the remaining soft costs will be. The bank also needs to be sure that the amount funded under any particular line item does not exceed the budgeted amount. And to be sure that no payments directly to the developer are being made before he has earned them.
Once the bank is convinced itself of all of the above, and received a consultant's report stating the work is in place and of adequate quality, the requested money is wired to the title company. A fax is also sent to alert the title officer that the bank has approved the draw request, and that the title company is permitted to disburse the funds once it is prepared to issue its date down endorsement. The title officer then does a title search to check if any new liens have been filed on the property. If none have, and assuming all the lien waivers from the general and sub contractors are correct and complete the title company will begin to disburse funds. Sometimes the title company will disburse money directly to the general contractor to pay the subs. Sometimes the title company will insist on cutting separate checks for each sub.
A week or two after the title company disburses funds, you should get a date down endorsement. You should check to make sure that it shows the correct date and amount. And if you do not get one you should call the title officer and complain. In truth, however, most title officers are not very people are not very diligent about sending out date down endorsements and most bank officers are not very diligent about hunting them down. There is a limit to how much anyone cares about all this paperwork.
Return to Chapter 3: Problem Loans - Continue to Chapter 5: Procedures