Using Best Practices to Mitigate the Domino Effect of Risk During Construction

Lessons from the Field: How Lenders Can Spot Trouble Early and Protect Their Investment

By Kyle Gustafson, National Client Manager, Partner Engineering and Science, Inc.; and Mark Petit, SVP, Operations Manager – SBA Lending, Meadows Bank

Originally Published in the 2025 CLRM Journal

Underwriting a commercial real estate construction loan for a small business is a complex and multifaceted process that requires thorough analysis. It begins with evaluating the borrower’s financial strength, including creditworthiness, management experience, operational cash flow (EBITDA), global cash flow, and the financial strength of any guarantors. Beyond assessing the business itself, lenders must also scrutinize the real estate component—considering factors such as property type, intended use, location, market conditions, as-complete appraised value, environmental risks, and zoning compliance.

In addition to these fundamental considerations, loan structure and terms must be carefully examined to ensure the business’ ability to sustain and service the required debt. When a construction element is involved, an additional layer of due diligence is necessary. Lenders must evaluate the contractor’s experience, conduct a comprehensive review of the project’s budget, analyze the construction timeline, and assess key documents such as contracts, plans, and specifications.

This article explores the complexities of underwriting construction loans for small business owner-occupied properties, focusing on both obvious and hidden risks, how to mitigate them, and best practices lenders should consider. Rather than centering on cash flow or EBITDA, we highlight specific construction risks and their potential impact on a project’s ability to meet financial projections or expected returns. Through real-world case studies, we aim to help readers gain expertise without the costly trial-and-error of experiencing these challenges firsthand.

Construction risks, both known and unforeseen, can create a domino effect, leading to major project setbacks. They are often complicated, nuanced, and require careful navigation to overcome. By outlining key risk factors and practical strategies, this article provides insights to help lenders keep construction projects financially viable and on track.

Due Diligence: A Key Component of Construction Loan Underwriting

Construction Risk Management (CRM) is a proactive approach to identifying and mitigating risks before they impact a project, rather than reacting to problems after they arise. It ensures loan proceeds are used appropriately and projects remain on track. Key CRM services include:

1. Document & Cost Review (DCR) – A thorough review of project plans, budgets, schedules, contracts, and permits to verify feasibility, completeness, and prevent costly delays or budget shortfalls.
2. Contractor Evaluation (CE) – Since the general contractor (GC) is responsible for project execution, evaluating their financial stability, experience, personnel, and safety programs is crucial to reduce the risk of contractor failure.
3. Construction Progress Monitoring (CPM) – On-site inspections provide real-time insights into a project’s status, ensuring work aligns with the budget, schedule, and contract terms. This oversight helps prevent fraud, mitigate disputes, and keep projects on track.
4. Funds Control / Funds Disbursement (FC/FD) – By auditing invoices, tracking payments, and verifying lien waivers, funds control ensures loan proceeds are properly allocated, reducing the risk of mismanagement, misappropriation, and contractor disputes.
5. Completion Commitment (CC) – If a contractor defaults or is terminated for cause, a CC provides a structured plan to complete the project using the remaining funds.

By combining progress monitoring with funds control, CRM services offer a cost-effective alternative to performance bonds while safeguarding against financial and operational risks. This oversight minimizes surprises, protects both lenders and borrowers, and helps ensure projects are completed on time and free of mechanics’ liens.

Even with strong underwriting practices, small business lending inherently involves challenges, unforeseen obstacles, and material risks—ranging from budget gaps to contractor issues and environmental concerns. As lenders expand their construction portfolios, their exposure to risk increases. While some view these risks as an unavoidable cost of doing business, others see them as growing challenges. The reality lies somewhere in between. The following case studies illustrate how hidden risks can escalate and how lenders can mitigate them with proactive measures.

Case Study 1: When a Fixed Price Contract Is Not Fixed

As most small business lenders know, the gold standard for construction contracts is the AIA Fixed Price Contract. In this case, a fixed price contract was in place for a large, multi-million-dollar ground-up project on an environmentally impacted site with contaminated soil (Phase I and Phase II were approved and on file). Additionally, this project utilized a Document and Cost Review.

At first glance, the project appeared well-vetted, with sufficient due diligence performed on the plans, specifications, budget, and contract. Even with an aggressive construction schedule, the project was deemed feasible. However, hidden risks lurked beneath the surface—both literally and figuratively. Due to insufficient scrutiny, several warning signs went unchecked. Clever contract language concerning delays and allowances distorted incentives, while a lack of vetting of the GC led to built-in change orders and cost overruns. The contract initially reflected a reasonable 5% profit margin, but that was not the full picture. Key issues in the contract included:

• Unclear Time-to-Completion Clause – The contract stipulated a six-month completion timeframe—which in hindsight, was overly aggressive. It included an “added time” charge for delays not directly caused by the contractor. However, this clause was poorly defined, allowing the contractor to trigger additional charges tied under the “General Conditions” line item, regardless of actual responsibility. As a result, the contractor had little incentive to expedite completion, costing an additional $30,000 per month in multiple change orders via the “added time” loophole.
• Environmental Contaminants and Cost Overruns – The environmental report projected $25,000 for contaminated soil removal, based on an estimated volume of soil. However, the contract did not specify a fixed dollar amount for this removal. Instead, it included a sub-category for potential change orders, setting a per-unit dollar amount for different soil types. Since contaminated soil required disposal at a specialized dumping facility, the removal rate was set at twice the normal price. As the project progressed, the actual volume of contaminated soil removed was significantly higher than anticipated. Because the removal cost was structured as a per-unit charge rather than a fixed sum, expenses quickly escalated. Trying to track and verify the exact volume removed proved extremely difficult amid change order receipts and environmental approval processes. As a result, the change orders for soil removal quickly amounted to several hundred thousand dollars.
• Costly Change Order Markups – This contract included a large 15% fee on all change orders. The contractor took a very loose interpretation of what qualified, significantly increasing project costs. This markup even applied to the contaminated soil removal, adding an additional 15% on top of the already inflated costs.

As you can imagine, legal action became necessary, and the project faced cost overruns in the hundreds of thousands. Fortunately, the borrower’s strong liquidity allowed the project to reach completion and open successfully. However, in small business lending, this isn’t always the case. For borrowers with limited liquidity, such overruns can jeopardize the entire project.

In this instance, environmental risks identified prior to construction resurfaced as unforeseen challenges, further escalating costs and delays. A few takeaways from this project include:

• Loosely defined contract terms should always raise red flags. Additional details should be required to ensure clarity for the borrower, lender, and contractor. Ambiguous language may not be accidental—it can be intentional.
• Even with a DCR, lenders should do their own due diligence. Question environmental cost estimates and consult specialists in remediation to understand total potential costs. Never rely on a single estimate—especially if based on a limited Phase II scope.
• Encourage borrowers to seek legal contract review for larger projects. A legal review before signing can help identify hidden risks that could lead to costly disputes.
• Environmentally contaminated properties require heightened scrutiny. Require multiple bids for remediation and cleanup to ensure costs are well-vetted and competitive.
• Internal due diligence checklists should be current and followed without exception. Consistently applying internal processes prevents costly oversight errors.

Case Study 2: An Inhospitable Experience in Hospitality—PIPing Ain’t Easy

In some cases, a Document and Cost Review (DCR) may be more than is necessary for Property Improvement Plans (PIPs), leading lenders to opt for a Project and Budget Review (PBR) instead. Unlike ground-up construction, PIPs typically require a more limited scope of due diligence. However, as this case demonstrates, failing to conduct a thorough assessment can lead to significant financial and operational challenges.

This case involved a hotel acquisition where the borrower was navigating a 1031 exchange, existing management issues, and a brand reflagging. Due to various factors, the loan needed to close quickly, and a PIP was required to renovate the property before the peak coastal summer season. A few key issues this project experienced included:

1. Waiving a Property Condition Assessment (PCA) – The lender waived the PCA requirement to speed up closing. A PCA provides critical insights into a building’s structure, systems, and overall condition, helping stakeholders anticipate repair costs and long-term maintenance needs. By waiving this step, major deficiencies in the building’s systems and infrastructure went undetected until renovations were underway—toppling the first domino in a chain of costly setbacks.
2. Waiving a Contractor Evaluation (CE) – The borrower selected a GC located several hundred miles away with limited experience in hotel renovations. While some regional GCs operate across multiple states, this contractor had a background primarily in residential construction and fix-and-flips. A review of the contractor’s permit history revealed that their past projects were significantly smaller in scope—four to five times less than the estimated cost of this hotel renovation. Since a contractor review was waived, key qualifications went unchecked and led to additional project setbacks.
3. Underestimating Permit Requirements – States, cities, and counties have different codes, compliance, and permitting requirements that should always be verified upfront. As part of the PBR process, a request was made for drawings, plans, and filed permit applications, which are typically required. However, the GC insisted permits were not needed, claiming the work was “only cosmetic and routine maintenance” and that replacements didn’t require permits. In reality, PIPs involving electrical, plumbing, HVAC, façade work, occupancy changes, fire systems, or sprinklers almost always require permits. Additionally, changing hotel flags typically triggers updates to lobbies and other key areas. Despite recommendations for further due diligence, the lender approved the PBR without verifying permitting needs due to the quick closing timeline. Shortly after construction began, a stop-work order halted the project due to unpermitted construction. This led to significant delays as the borrower had to pause work, file drawings, submit permit applications, and wait for approvals before construction could resume.
4. Discovering Major Structural and Mechanical Deficiencies – Once renovations began, the borrower and GC encountered unexpected structural and mechanical issues, significantly expanding the project scope. What was expected to be a simple FFE replacement, flooring, and paint refresh turned into full-scale renovations, with many rooms needing to be taken down to the studs and rebuilt due to plumbing and electrical deficiencies. Beyond interior work, major building systems required costly repairs. Many HVAC units had exceeded their useful life, requiring full replacement, and the elevators required extensive repairs or replacement. Additionally, windows on the south-facing side were deteriorating, with warped frames and water intrusion worsening façade issues. The out-of-market contractor lacked strong subcontractor relationships, making it difficult to stay on schedule.
5. Missing the Peak Tourist Season – Because of these delays, cost overruns, and permitting issues, the renovation was completed months behind schedule, missing the peak summer tourist season. The interest reserve rate (IRR) set aside to cover expenses during construction was depleted before the hotel could stabilize its cash flow, further straining the borrower’s financial position.

A few takeaways from this project include:

• An out-of-market general contractor requires additional vetting. Lenders should verify the GC’s experience, financial strength, and familiarity with the local market before approving the project.
• A Property Condition Assessment (PCA) should never be waived for acquisitions involving major renovations. The capital expenditure tables within a PCA can help validate whether a PIP’s budget is realistic.
• Permitting requirements should always be verified upfront. Contractors who claim permits aren’t needed should be met with skepticism.

Every construction loan aims to deliver a completed, fully functional business—on time, lien-free, and within budget. However, construction risks are ever-present, and the borrower is most vulnerable during the build period.

Proper due diligence can help identify and mitigate many of these risks, but challenges can still compound unexpectedly. While these projects ultimately reached completion, these case studies illustrate how setbacks can escalate when risks are underestimated and highlight the importance of identifying red flags early.

While risk cannot be eliminated, it can be managed. Open communication, proactive oversight, and strong lender-vendor partnerships are essential to successfully navigating construction lending.