Mitigating Construction Loan Risk

Construction lending risk is a significant concern for lenders like Lima One Capital Capital, from the contract phase to pre-construction, construction, and final payment. Successful lending relies on our ability to manage and mitigate those risks throughout the project. The risk falls primarily into four categories: overfunding, funding work that’s not complete, funding trades that are never paid and business plan execution.

Overfunding usually begins in the contract phase when a project is overvalued, and the lender fails to catch the discrepancy. This can happen for a number of reasons, from a developer or contractor inflating the project costs to simple inexperience. Much of the time it is loaded into soft costs to front-load a budget with the goal of providing “back door” working capital. Regardless of the reason, it is a major vulnerability for the lender because if the developer defaults, the lender may not recover the loan value with foreclosure. At Lima One Capital , our Construction Management group reviews every budget with the goal of eliminating this risk. This analysis is not only a risk mitigant, but a value-add for our sponsors to make sure contractors are not overcharging.

Construction funding is usually provided on an as-completed basis in our space, meaning that the contractor is authorized to request “draws” on the funds as previously agreed-upon portions of the work are completed. This presents a risk for the lender if a contractor is not accurate in stating the amount of work completed. This is the reason we use disinterested third-party inspections, proprietary inspection software, and a robust analysis of each draw request. Through this process, we reduce the risk of releasing more funds than the value we receive in return. The goal is to not only make sure enough funds remain in the budget to complete the project, but that the LTV (Loan to Value) decreases over time as well.

With construction loans, lenders very rarely interact directly with subcontractors. Instead, the owner signs the construction loan contract, and the bank pays either the owner or general contractor directly. The general contractor pays its expenses and profit and then pays the subcontractors. In some cases, however, a sponsor does not pay their contractor or because of higher-than-expected contractor expenses or unscrupulous contractors, subcontractors never get paid. When this happens, a contractor or subcontractor has the legal right to file a lien which puts the lender’s security at risk. Requiring lien waivers can eliminate or at least reduce this risk. Additionally, a title date-down endorsement can provide insurance against any legal actions taken as the release of escrow.

To mitigate construction loan risk, we use three primary tools: Feasibility Reviews (scope and cost) and Contractor Acceptance Reviews pre-close. Feasibility involves reviewing plans and specifications to ensure that they are complete and accurate and that they meet all applicable codes and regulations. The review also includes an assessment of The Big Three- Structure, MEPs (mechanical, electrical, and plumbing) as well as Health and Safety. These are typically where you see costs under-budgeted, or cost overrun later in a project as they are the most expensive to change or correct.

Draw Inspections and Analysis are used post-close to mitigate construction loan risk as funds are released. These inspections are conducted by an independent third party who verifies that work has been completed according to plan and specifications before any funds are released.

Mitigating construction lending risk requires careful planning and execution throughout all phases of construction lending. By using Feasibility Reviews, Contractor Acceptance Reviews and Draw Inspections lenders can help ensure that their loans are successful for sponsors while minimizing risks to the investor.

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