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Risk Management Tools for Construction Lending

September 15, 2023

The resource-intensive business of construction lending has primarily been the purview of the big banks, but in recent years, smaller mortgage lenders have increasingly broken into the industry. Historically, mortgage banks have lacked the capital to become competitive in the construction lending space; this all changed with the advent of warehouse capacity, a specialized line of credit provided to mortgage bankers by warehouse lenders.

This is great timing: while the demand for loans is currently robust, there is a dearth of capacity in the lending industry across the entire country, and mortgage institutions are ideally situated to step in and seize a chunk of the market share from the big banks. However, construction is a notoriously risky business; because no two projects are alike, it’s a challenge for newcomers to adequately manage their risk, which can lead to delays and even failure. As mortgage banks lack a built-in knowledge base on the risks of the construction business, in order to capitalize on the market (and ultimately, to scale the business), they need to make sure the following risk- management strategies are in place: 

1. Evaluate and document the costs

Prior to construction, and before the loan even closes, there must be a comprehensive costing review, which determines whether a project is feasible within the proposed budget. The resulting analysis should determine whether the loan is sufficient to complete the project within the given conditions; factors like size, scope, and location of the build greatly influence whether a proposed budget is viable. For a project assessment, if there are insufficient funds to build the home, the project can be at risk from the day the loan funds.

A sound costing assessment must also systematically take into consideration many other aspects of a project’s logistics, including building plans, materials, permits, and environmental reports. All documents considered must be evaluated for completeness and verified to be up-to-date. Applicable laws, permit requirements, and costs vary wildly by location so it is vital to have access to a comprehensive database that provides up-to-date information about costs, state policies and lien laws.

Typical questions that arise during a costing review include: 
Are projected costs typical for the area? 
Is the valuation appropriate? 
Is the contract between borrower and builder reasonable to protect both borrower and lender and ensure the home is built?

2. Review the contractor’s bona fides

Closely related to the costing review process, the contractor evaluation is another key component in mitigating a project’s risk before the loan is finalized. Also known as builder validation, this assessment should indicate whether the intended contractor is qualified to build the project from start to finish. The evaluation is based on criteria like previous experience with projects similar in size and type, whether those projects were completed successfully, their track record in successful completion of these projects, reference checks from subcontractors, suppliers, and clients; licenses and insurance, among other considerations. 

Lenders that fail to thoroughly vet contractors are vulnerable to mechanic’s liens, which can become a security interest in a property title that acts as a guarantee of payment for contractors, suppliers, subcontractors, and builders. For example, if a contractor doesn’t pay their subcontractors for their work, the subcontractors can file a mechanic’s lien to secure interest in the property until their bill is paid. Meanwhile, now it’s the property owner who is on the hook for work completed or material provided; if they can’t work out a deal with the subcontractors, they can be sued by the subcontractor.

This situation, seen from a lender’s perspective, boils down to this: if your contractor can’t complete the project, it will be transferred to a different contractor at a higher cost, putting the entire project, and the loan itself, in jeopardy. The risk of mechanic’s lien can be greatly mitigated by completing their due diligence into the contractor’s credentials in combination with a good fund control process.

3. Funding control

After the loan is closed, the funds need to be disbursed to keep the project moving forward. Some companies specializing in fund control will simply follow a predetermined plan for releasing funds and managing the budget, but a rigid, templated approach can lead to problems down the road. A good fund control provider needs to be able to hone in on trends, respond appropriately, and make sure everything is thoroughly documented and reported, ensuring that the projected funds disbursement is accurate and on-budget. A good fund control process will also ensure that the budget for the project is on track, which will assist in avoiding change orders.