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Sponsored Content from GoDocs: Guide to Construction Loan Issues for the Commercial Loan Market

Commercial construction is ramping up again as developers pursue new business opportunities.

After the recession of 2020, commercial construction is ramping up again as developers pursue new business opportunities. This means that more people are turning to commercial lenders to fund new construction or renovations. While this can be an exciting time, it is important to enter the loan and construction process with a clear understanding of how it works, the challenges that will arise, and how to avoid potential pitfalls.

Gaining a deeper understanding of the current market and other important issues related to commercial loans will help you to partner with the right lenders and set yourself up for success.

Current Market Demand for Construction Loans

The first step in securing a commercial construction loan is to provide proof that there is a market demand for the project. You will need to show that it is supported by current occupancy rates, market rents, and operating expenses. On larger projects, a market study typically is ordered to support the underwriting for such loans. On smaller projects, the developer and lender will research market demand.

As of 2021, the demand for new apartment complexes and tract housing developments hit historic highs. According to the National Association of Realtors, the following market factors are increasing the demand for new housing projects:

• The total inventory of available homes for sale declined by 17.9% over 2021, and the inventory of homes available for purchase is down 60.4% compared to 2020 before the onset of the COVID-19 pandemic.
• Newly listed homes are down 9.1% nationally compared to a year ago, and down 11.6% for large metros over the past year.
• The January 2022 national median listing price for active listings was $375,000, up 10.3% compared to last year and up 25.0% compared to January 2020. In large metros, median listing prices grew by 6.1% compared to 2021, on average.

In addition, apartment rents are skyrocketing because of the lack of multifamily housing. The combination of these factors is driving demand for new construction, which will also stimulate job growth.

Looking toward the future, the scarcity of affordable housing is forecasted to continue for the next two to three years. As a result, bank and private lenders are now adding or expanding their construction lending teams. Moreover, Real Estate Investment Trusts (REITs) are being formed in order to purchase. The influx of cash into this sector of the economy will further heat up the construction market as more apartment construction loans are awarded.

Common Concerns for Construction Lenders

As of June 2021, the U.S. housing market needed 5.5 million more units, according to a report by the National Association of Realtors. This incredible need for housing in now-gateway cities presents an opportunity for lenders to provide construction loans to fill this void. For a construction loan to be successful, lenders must maximize the possibility that every project will meet the following three objectives:

• The construction goes ahead as planned and budgeted;
• The project is completed on schedule and paid back on time; and
• The lender makes money on the loan.

Let’s take a look at various construction loan risks that lenders face and need to manage and mitigate by (i) conducting thorough underwriting for the potential financing for their construction projects, and (ii) ensuring that their construction loan documentation is detailed and tailored to address these concerns.

Non-Completion of the Housing or Apartment Project Within the Term of the Interim Construction Period

If the budget is improperly managed, funds can run out before the project has been completed. One of the most important ways of preventing this outcome is to ensure that the loan’s construction holdback is calculated and managed correctly. Builders should never receive more funds than is supported by the percentage of work that they have completed as verified by construction progress inspections.

Draw inspections and disbursement controls are essential tools that help properly maintain balance sheets all the way through to the end of the project. The lender has certain responsibilities when it comes to appropriating funds. These include ensuring that:

• The construction loan remains in balance at all times;
• The undisbursed funds remain adequate to complete the improvements; and
• Draw disbursements are released only for work completed.

No Progress Reporting

Reporting ensures that construction is proceeding on schedule relative to the term of the loan and the completion date referenced in the construction contract and the construction loan agreement. While some lenders choose to only request progress reports at the time of a draw request, thorough construction loan documents should permit the lender to conduct monthly (or more frequent) progress inspections regardless of whether a draw application has been made.

Progress reporting also allows the lender to ensure that construction workmanship and progress are in balance with any funds requested through a draw application.

Lenders can require that the borrower permits the lender to have its trained professional inspectors (at the borrower’s expense) to enter the project, obtain contractor/architect/engineer certificates, and obtain progress lien releases. These inspections can produce detailed reports verifying that draw application requests are supported by the improvements made.

Missing or Incomplete Project Budget or Paperwork

The lender can reduce this risk by performing a detailed project review itself, or by enlisting a qualified vendor to perform a review before the loan closes. These kinds of pre-checks will save time and money in the long run by saving lenders from costly litigation over the construction contract.

A project could also be delayed before it even gets off the ground if other essential paperwork is missing or incomplete. At a minimum, an initial review should include an appraisal report, a budget review, permits, and a construction contract review.

Project Not Completed in Accordance with Appraisal Report

The proposed construction appraisal shows the future value of the property, and the final completion report assesses if that has been achieved. Unfortunately, by the time a lender receives the final report, the damage may have already been done.

Insufficient, faulty, incomplete, or defective construction will reduce the value of the property in comparison to the original estimated value on which the loan is based. This could jeopardize the lender’s interest in the collateral and the funds that will be generated by the sale of the unit used to pay down the outstanding balance of the loan.

Construction loan documents should permit a lender to have the collateral property regularly inspected to ensure that the progress of the project is meeting the loan-to-value standards set out in the appraisal report and the loan-to-cost requirements set forth in the budget.

Without these protections spelled out in detail in the loan documents, the loan may not be paid off pursuant to the loan’s repayment terms or would become non-salable on the secondary mortgage market. 

Lack of Insurance Leaves Lenders Unprotected

No amount of paperwork, planning, or budgeting can protect a construction lender from every eventuality, which is why key insurance policies are put into place before construction starts. The following types of insurance are necessary for the borrower to maintain in order to secure the build:

• Private Mortgage Insurance (PMI): Protects you in the event that the buyer falls through;
• Builders Risk Insurance: Protects the property during construction from fire, wind damage, theft, vandalism, and other disasters; and
• Builder’s General Liability: Protects the property from damage as well as physical and reputation-based injuries (also protects the contractor from being held liable for any work completed by subcontractors).

Failing to Protect the Construction Lender’s First Lien Right

Lien waivers are essential to ensuring risk-free disbursement of construction loan funds. Lien waivers are used as a tool to protect a lender’s lien position and to avoid liens that (i) complicate and delay projects and (ii) put the lender in a position where its first lien position can be subordinated to mechanics’ liens. Lenders need to make sure that they maintain first lien position throughout the construction period and after each loan disbursement. Lost lien priority puts a lender in danger of losing its control of disbursements.

As part of best practice, a lender must ensure the following as part of its loan documentation:

• Waivers are completed according to local and state regulations;
• Waivers must be completed on the correct form and submitted on time; and
• Payment is only given for work completed or materials in place.

Disbursing Construction Loan Funds without Title Updates

Another important way a lender can protect its lien position is by ordering a title update and title insurance progress endorsements at each draw. This action ensures that no mechanic’s or subordinate liens will take priority over the mortgage or deed of trust.

Traditionally, ordering title updates has been cumbersome and required numerous steps. This meant that it could take anywhere from three to five days to receive the report. Fortunately, recent advances in technology have enabled a digital title update process that provides a faster and more seamless operation. Title updates should include:

• Current deed information (i.e., grantor, grantee, recording dates);
• Property tax status, when available;
• Lien and judgment information (i.e., creditor, amounts, and recording dates); and
• Copy of the most recently recorded deed.

No Assignment of Project Rights and Contractual Obligations

If the situation arises, when the borrower walks away from a project and a lender needs to take over the completion of a project, it is essential that the construction loan documents clearly state that the lender will assume control over the construction plans, construction contract, permits/licenses/approvals, architectural plans (together with the architect’s contract), and engineering plan. 

Without these provisions, the construction project will be left in limbo and the lender’s hands will be tied.

Conclusion

Commercial real estate is not just another investment opportunity for developers. It is an essential tool to provide people, even in the country’s biggest cities and most competitive real estate markets, with affordable housing. When demand for housing exceeds supply, commercial loans can help fill in the gaps and work in the best interest of everyone.

Proper loan documentation will provide a construction lender with options, protections, prospective, and reactive controls to address the various risks that are posed when financing a construction project.