Construction Lending Can Be Risky and Complex but Does it Have To Be
September 7, 2023
In recent years, many types of lenders have shown an unprecedented interest in breaking into the construction loan market. Green Street Advisors estimates that U.S. originations by non-bank lenders rose by 40 percent in 2017 alone. Still, construction lending poses a unique set of risks that can leave lenders who are unfamiliar with this space dangerously exposed. Indeed, the rise of non-bank lenders and smaller banks is largely a reaction to the financing vacuum left by more tightly-regulated big banks after the 2008 financial crisis. Seizing the profit potential in construction loans depends on accessing the expert knowledge needed to create and execute a responsible lending policy.
The risks of construction lending
In a typical real estate transaction, lenders have the security of an established asset: a finished home or commercial building. In a construction loan, on the other hand, the collateral may be nothing more than a vacant lot and borrower equity. Determining an appropriate loan amount requires a great deal of confidence that the value of a finished project will hold up to its original appraisal. Even more crucially, lenders must have the utmost confidence in the costing and budgeting to ensure that the property can be completed with the projected budget. Also of critical importance is validation of the general contractor’s character and credentials to complete projects of similar scope to the subject property.
As anyone who has ever remodeled a kitchen can attest, not all contractors are created equal. If a contractor fails to pay their suppliers or subcontractors, those parties have the ability to file and enforce what are known as “mechanics liens.” These liens generally take priority over all other money financed after the date their work started, and if a contractor disappears, they can leave lenders holding the bag for significant sums. To avoid the risk of mechanic’s liens, lenders must establish strict inspection and fund control protocols, to ensure construction is proceeding as scheduled, no draws are made before the commensurate amount of work is completed and the appropriate suppliers and subcontractors are being paid appropriately
Construction loan risk also varies across different markets and in response to market forces. Regulations governing mechanic’s liens differ from state to state. Anticipating demand for new developments in a given area requires a deep understanding of the ebb and flow of real estate cycles. Even the cost of materials can throw a wrench in a project budget. For example, as a result of tariffs, the overall cost of construction materials rose 9.6 percent during 2018, the sort of spike that can cause subcontractors to default and the entire budget to fall apart.
Partnering with a construction management partner
For lenders who are new to the construction loan space, or who have had bad experiences in the past, merely educating themselves on a project’s merits can be so daunting that they never move forward with the process. After all, a lender’s core competency is originating and underwriting loans, not judging whether a subcontractor is undercharging for drywall.
Contracting with a construction risk management company like Granite Risk Management ensures that lenders are in the best position to make a profitable loan and avoid headaches and lawsuits. Granite provides end-to-end risk mitigation and consulting to lenders who want to start a construction loan program or make changes to an existing program. Granite’s process takes place in three stages: pre-close, post-close and completion.
The pre-close process entails a thorough assessment of whether a project and a contractor can deliver promised returns. For contractors, this involves an underwriting process that includes a full background, credit, and reference check, and tracking of the relevant insurances and licenses. If a contractor’s character or qualifications are not satisfactory, lenders can assume that the construction process will be challenging. Likewise, Granite conducts project underwriting to ascertain that a project’s budget makes sense for its size and scope, as well as analyzing the builder’s contract. These assessments are not merely the product of personal expertise but estimating software that provides the most up-to-date information about construction costs.
Once the loan has closed, Granite can supervise inspections, fund administration, state-level statutory compliance and disbursement to the contractor. Familiarity with the construction field makes a risk mitigation partner able to accurately assess when a change order is the result of an understandable adjustment or a sign of a project going sour. Granite can supervise the loan through project completion, undertaking a final inspection, Certificate of Occupancy, and a final disbursement to the contractor. Maintaining this level of control over project funds is the surest way to avoid mechanic’s liens, because it doesn’t give contractors the opportunity to misappropriate funds. However, this level of oversight requires both a dedication and expertise that most lenders don’t possess on their own, making a reputable partner indispensable.
Partnering with a title services provider
Aside from lending to trustworthy contractors and soundly conceived projects, the surest way to maximize profits on a construction loan is by streamlining the closing process. After consulting with construction lending clients, Granite and Premium Title developed the Construction Title Pro (CTPro) program. This industry-leading solution saves lenders and consumers money by eliminating the redundancy of the lender’s risk mitigation process and the title company’s risk mitigation process.
CTPro accelerates the draw process, minimizes property inspection/survey requirements, provides title coverage on pre-start transactions and allows lenders to disclose with confidence, since Premium Title guarantees its construction title fee quotes. By seizing on these efficiencies, CTPro enables lenders to expedite the construction loan process from origination to project completion. In the current market, which is crowded with eager lenders and challenged by demands for timely contractor payment, CTPro provides lenders a competitive advantage.
Loan with confidence
Some degree of risk is inherent in all construction lending, but without the expertise of risk mitigation professionals, it can feel like sharpshooting in the dark. Granite’s suite of services turns the lights on, enabling lenders to clearly see whether a given project fits with their risk appetite. By managing a loan’s life cycle with precision and control, Granite empowers lenders to enter this exciting and rewarding market with confidence.