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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   February 2008

Construction Lending's Moving Targets

Get on track to address the four primary risks of construction loans

Construction Lending's Moving Targets

In commercial construction and construction-completion transactions, lenders focus primarily on what could go wrong with a deal -- aka, the risks. They seek to protect themselves from loss.

To be successful with these kinds of loans, brokers should anticipate and address the risks of each project upfront. This can save an enormous amount of time for borrowers and lenders as they enter a negotiation phase.

Ultimately, it will prepare the borrowers for the lender's requirements, and it will assure lenders that their time spent in underwriting won't be frustrated by borrowers with unrealistic expectations.

Unlike conventional loans, in which brokers can identify and quantify most elements and risks upfront, construction loans involve more unknowns and uncertainties. Working on these loans is like shooting a shotgun at clay targets. It's imprecise. The target and shotgun are in motion.

Lenders typically scrutinize four different types of liability with construction loans. For each one, there is a means of mitigation and of covering the lender's "bet." To be successful in brokering construction loans, know the specific kinds of risks and how best to address them.

Construction-loan types

First, you must understand the different types of construction loans.

Pure construction loans can be thought of as cradle-to-grave loans. With them, lenders provide funds for construction. The construction loan is then paid off with a longer-term, lower-cost permanent loan.

Mini-perm loans focus on funding the construction itself. They provide the financing to get the job done. They are then replaced by funds obtained elsewhere.

Follow-up or takeout loans are called permanent loans. Essentially, they pay off the construction loan upon completion of construction.

Determining which type of loan fits with which borrower -- and which lender -- will depend on the facts of each loan opportunity. Construction lending is anything but plug-and-play.

Construction risk

This particular liability extends beyond the borrowers' and lenders' control and encompasses construction-cost overruns and delays. The concern is that the project will not be completed. For example, contractors could walk off the job, material could not be available or unforeseen building conditions could arise.

Time also is a factor. Delays push the break-even point of the project further into the future and generate additional risk exposure.

There are many ways to alleviate this risk. The most straightforward way is to increase the amount of "skin" the borrower has in the deal. This can include applying lower loan to values (LTVs) or requiring that the borrowers have and maintain greater cash reserves. Another way is to cross-collateralize the construction loan with borrowers' other properties or guarantees.

4 Construction-Loan Risks

Construction risk: The project will not be completed on time or within budget.

Carry risk: The loan will default in interest payments during the construction or lease-up period.

Takeout risk: The balloon payment will not execute as planned.

Real Estate Risk: The economics of a property will not perform as expected.  

Lenders also might want to oversee a construction-draw schedule or have an independent builder-control company do so. With this kind of schedule, the funds are disbursed according to agreed-upon phase completions. The payments go directly to subcontractors and material providers. This typically costs borrowers a point of the total loan amount, however.

In some cases, your borrowers also can purchase bonds -- performance, payment or completion. These ensure that the project actually will be completed. The downside is these bonds are expensive and often difficult to enforce. They also come up short in protecting a lender, as they cover only construction costs.

Carry risk

During every second of a construction project, interest is accruing. Carry risk is the threat that interest payments will be delayed or stop altogether before the project is leased up.

The most straightforward tool for easing this scenario is prepaid interest. The lender simply takes the interest it will be owed for part or all of the project at the outset of funding the loan.

In addition, borrowers can establish separate carry-reserves, extending beyond the construction itself to costs such as real estate taxes and insurance. Your borrowers can enhance or replace reserves using mechanisms such as credit insurance -- a policy that insures that carry-risk items will be paid -- and letters of credit.

Pre-leasing space to tenants is another potential solution, with tenants covering debt service and expenses before taking occupancy.

Takeout risk

This is the risk that a new, lower-cost loan will not be available at the end of the construction phase. For borrowers and brokers, this concern can be eliminated by arranging for a pure loan at the outset.

Unfortunately, this isn't always possible. Lenders offering lower-cost loan products will want to see the property's income history and stability, which can be tough when the project is still only a set of drawings and an idea.

By demonstrating to the construction lender that takeout financing is highly probable -- or even better, already in place --you can create borrowing opportunities and lower the cost of capital for your clients.

The best way to do this is to get tenants signed up ahead of time. If you can't do this, you'll need to illustrate the developers' past experience and success with similar projects. Showing the lender comparable projects that the developers have completed are a great way to make the case that the future will unfold as planned.

Highlighting the progress of the construction project itself can also help you obtain a takeout. By demonstrating that the borrowers have performed as promised on the current project, within the parameters of carry-reserves, you can show the lender the borrowers' reliability. In making timely interest payments on funded loan proceeds during the project, your borrowers prove they can also make timely payments after the project is complete.

The key is to seek takeout financing as soon as possible after your borrowers get the construction financing. This can be tougher than it sounds.

Borrowers are intent on the construction itself, and they are usually tired of the funding chase. The last thing they want to do is assemble yet another due-diligence package for yet another lender. It is incumbent upon you to drive the effort, however, even if it is overshadowed by the construction at hand.

Real estate risk

This is a macro-consideration. It looks at whether the project will be worth the original amount projected upon completion. With commercial properties, value is a function of the ability of the building to generate income, not just the state of the local real estate market.

This isn't to say that buildings don't stand empty after completion. It happens all the time. But the underlying value remains. The building is still there. It can serve as security for funding of some type. The challenge is to demonstrate to a lender what this value will be and how the lender will be protected even in a worst-case scenario.

You have to play an advocacy role for your borrowers -- marshalling facts and arguments much in the way an attorney does for a client. Describe the property, comparable properties and the local environment thoroughly enough to convince the lender that extending a loan on the property presents an acceptable risk. Paint a picture of the future that the lender can see and understand.

Addressing the risks

As with any commercial loan, the basics apply for how to present the best-case scenario to the lender. To address the risks upfront, you should thoroughly review the project, collect documents and prepare an executive summary. Make sure to consider the loan size, property type and location.

Construction lenders generally post their application requirements on their Web sites. Download the forms, complete them and submit them in a timely manner.

Be prepared to provide extra details, such as:

  • A project description with timeline and budget assumptions;
  • Borrowers' information, including their background, résumé, and personal and corporate financial statements;
  • Basic loan terms; and
  • Takeout lender, if identified.

•  •  •

Although they have more moving parts and include variables and considerations that can seem mind-boggling at first, construction loans provide enormous opportunity to brokers. With enough focus and determination, you can hit your target.

More important, there may be other targets to follow. After all, one borrower and one property may result in multiple additional loans for you.


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