Ensuring thorough risk management policies for construction lending
By Bill Tryon
Construction is on the uptick, cranes are back in the sky, and it’s tempting to get back into construction lending. But is your community bank really ready?
Successful real estate lending is challenging enough. Adding a construction component makes things that much more difficult, because the collateral tied to these loans often doesn’t even exist when these loans are made. To succeed, these projects require careful planning, oversight and market knowledge on the part of the developer to anticipate and address risks from concept through completion of the project. Without close oversight, just too many things can go wrong.
Even lenders that are not subject to the Office of the Comptroller of the Currency’s requirements can benefit from guidelines included in its Comptroller’s Handbook on Commercial Real Estate Lending. Though the specific controls employed by lenders are subject to their individual risk appetite and the markets they serve, the OCC suggests that construction-development lenders:
- determine acceptable loan types and limits, including sub-limits, defined by property type, geographic market and other relevant factors where appropriate;
- maintain sound analysis and underwriting processes to evaluate the quality of loan opportunities and help mitigate risk;
- establish minimum standards of documentation;
- implement sound loan administration and monitoring programs; and
- maintain disbursement controls.
Many issues can arise during a development project that can seriously compromise the lender’s position. Risks can include inadequate engineering plans, contractors not following plans, or costs incurred through change orders needed to correct overlooked errors. The OCC suggests a number of specific tools and procedures which can help to minimize such risks.
The building blocks
Feasibility analysis provides a useful tool in underwriting construction loans. The feasibility analysis evaluates the likelihood that a project will be economically successful; in other words, create value above the project’s cost. The study may be completed as part of the appraisal, or as an independent report. The feasibility analysis should consider conformance of the completed project with legal uses of the property; analysis of the site, demographics and market; and review of costs and time required to complete the improvements (including land, construction costs, fees, profit, interest and all other development costs), as well as the value at sale or stabilized occupancy.
The value assumed in the feasibility analysis should be compared with the value determined during independent appraisal of the property. In addition, the OCC suggests the critical review of any reports provided by the borrower to minimize the potential for conflicts of interest.
Reviewing plans and budgets is another critical element to manage risks in underwriting construction loans. Appraisal and feasibility studies sometimes consider a cost approach to value; however, the extent of the reviews is generally cursory, providing little more than a general sense of adequacy. A more detailed review of construction documents is frequently warranted.
At a minimum, a meaningful assessment will include the review of architectural and civil plans, the overall project budget and detailed line-item budget. The reliability of the review can be improved by evaluating additional drawings, geotechnical and environmental reports, construction schedule, as well as the survey and zoning approvals. The review of construction documents should also take into account special project considerations. For example, the review may be helpful in the evaluation of critical completion dates and verification that tenant requirements have been appropriately reflected.
Once a construction loan has been made, “effective control procedures” should be put in place, including “segregation of duties, site inspections, budget monitoring, and dual approval of loan disbursements,” according to the OCC handbook. The lender should not advance funds unless the funds are to be used solely for the project being financed and as stipulated in the draw request and governed by the loan agreement.
Monitoring of the progress of construction is another critical control in construction lending, though the scope of monitoring varies among lenders and depending on product and borrower types. Before funding improvement costs, lenders should verify appropriate permitting. Throughout construction, lenders should verify that improvements in place are in substantial conformance with the bank.
This means that approved plans and payments made are for work completed at the property and that remaining construction funds are adequate to complete the work. Monitoring of holdups can also be critical, since delayed completion may increase interest and other fees, making the project less feasible.
In addition, foundation endorsements are sometimes used to verify the correct placement of foundations at the property, and title date-downs and unconditional lien releases can be useful in confirming payments to subcontractors. Periodic review of the financial statements and credit reports for the developer and contractor can also help the lender to identify problems early in the development process, while review of leasing and sales reports can help to evaluate performance versus the pro forma or feasibility analysis.
Ensuring such review and monitoring practices are incorporated into your community bank’s construction loan underwriting and administration policies and procedures will allow it to identify—and address—issues upfront. This will prevent the need to retroactively rectify missed conditions, which can be complicated and expensive and quickly cause a project to run over budget and schedule.
Both the Dodd-Frank Act and the OCC recommend that lending policies be appropriate for the size, nature and scope of lending operations and should reflect the lender’s internal risk tolerance levels. Proactive risk management policies ensure construction lenders remain compliant and adequately protected against liabilities and losses.
Bill Tryon (email@example.com) is director of strategic development for Partner Engineering and Science Inc., a national engineering, environmental and energy consulting firm based in Torrance, Calif., serving the commercial real estate industry. He has more than 30 years of experience in developing risk management policies and procedures for environmental due diligence and construction risk.