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October 25, 2018

Denver’s Booming Construction Underscores Importance of Risk Management Services

By Lane Schwarzberg


If it feels like everywhere you go in Denver there is seemingly a crane in the air, that’s because there is! Construction activity abounds, development is booming, and the Front Range is an expanding cosmopolitan mecca. In addition to a red hot multifamily market, Denver ranks among the top 10 cities in the United States for office development. Indeed, the Denver-metro area was recently ranked as the seventh-best investment market in the entire Western Hemisphere.

Despite all the positives of a thriving commercial real estate market, with increased volume also comes an increase in default risk, either due to financial mismanagement and contractor or subcontractor performance. In the rush to participate in competitive markets, developers may rush projects on the front end, while contractors may take on too many projects or projects outside their direct realm of expertise. Growing costs of material goods for construction and widespread labor shortages are also a cause for concern in the industry. Now more than ever, it is essential to manage risk to ensure that projects are completed on schedule and on budget from start to finish.

Historically, performance and payment (P&P) bonds have been the traditional way to manage construction lending default risk. Unfortunately, not all projects qualify for them. Projects that cannot be bonded or will have difficulty obtaining a bond include houses of worship, projects where the owner is also the contractor, projects with foreign ownership, projects with groundwater contamination, and many others. Newly established contractors may also be unable to qualify for bonding due to lack of experience. Moreover, the process of filing and claiming a P&P bond may take months or even years to resolve, during which time the construction project may dissolve and the site and materials possibly obtain damage.

There are many compelling alternatives that are proactive in nature are gaining popularity in the industry and approval by regulators. These alternative construction risk management tools are more proactive, thereby lowering the risk of default, and provide more direct control and real-time information over the course of a construction project. Most importantly, they cost much less.

For a $10 million-Dollar construction project, a typical performance and payment bond will run between 1% and 1.5% of the project costs ($100,000 to $150,000), while for a similar  project (lasting 18 months) the construction risk management program fee would be around $45,000 and include proactive tools like contractor evaluation, document and cost review, construction  progress monitoring, and funds control and disbursement, all of which significantly lower the risk of default or project failure.

Document and cost review—also known as an initial plan review or pre-construction cost review—is used during the underwriting process to evaluate project plans and specifications. The project’s budget, schedule of values, and scope of work—as well as the owner/contractor agreement and any other relevant documents— are evaluated to determine project viability within the anticipated budget, schedule, and funds allocation presented by the general contractor. Concurrently, the provider will underwrite the abilities and capabilities of the general contractor (GC)—a process known as contractor evaluation. The lender normally underwrites the borrower or loan at hand, and the document and cost review determines project constructability. But without evaluation of the contractor’s experience, licensing, and project management capabilities, no one would be underwriting the GC (or any additional subcontractors), one of the most important entities of the construction process.

Construction progress monitoring consists of frequent, routine site inspections throughout the lifetime of the project to independently verify that construction progress is occurring on schedule and on budget based on the established milestones and funds requested from the contractor. Site observations are conducted in conjunction with each disbursement request to determine percentage completion by line item. This is an essential tool for assessing conformance with the provisions of the construction loan agreement, addressing and correcting any work hindrances, and tracking and processing approved change orders.

Funds control/disbursement, also known as pay application audit and disbursement, is the key financial function of the construction risk management process. The backup invoice support from subcontractors and suppliers is collected and matched with a schedule of values, comparing each line item’s percentage of completion as observed during construction progress monitoring. The pay application request is then audited and individual payee checks are cut directly to the appropriate subcontractors and suppliers. The funds control component ensures that the money is going into the intended project at the appropriate pace according to the work completed and is not being diverted and comingled with another project’s funds. It is the critical component that enables the bond-alternative program to be used in lieu of a bond. Some lenders may choose to use individual components, such as just the contractor evaluation, document and cost review, or construction progress monitoring. But without the funds control/disbursement, they may still need the P&P bond.

Paired with physical and environmental due diligence, a comprehensive construction risk management program allows for early identification of problems and for corrective measures to be taken proactively throughout the construction process to help prevent a default.

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