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Before Issuing a Construction Loan, Examine Costly Risks

Before Issuing a Construction Loan, Examine Costly Risks

Lending for real estate construction carries unique risks. There are many variables that can ultimately affect the successful completion of the project. For example, if construction planning is inadequate or not detailed enough, it could lead to delays, errors or change orders. An unrealistic schedule of completion milestones may result in shoddy work quality or completion delays. An unqualified or inexperienced General Contractor (GC) may run into issues managing project nuances and related budgets. Ultimately, costs rise significantly, contingencies are difficult to plan for and, in worst-case scenarios, the project may not even be completed or may default.

Lender concerns during the pre-closing period are focused on weighing the value of a completed property to value of the loan, and ways this value could be diminished. This can include the reputation and reliability of a GC (which can be further vetted with another pre-closing tool called a Contractor Evaluation), cost overruns, disruption or project termination risk, unexpected site conditions or challenges, feasibility of proposed construction, and reliability of cost estimates.

An independent Document and Cost Review (DCR), also referred to as pre-construction document and cost analysis, can help mitigate these risks by proactively preventing costly mistakes with a detailed pre-closing project evaluation. For borrowers and lenders, a DCR protects liability and disbursement of project funds, as construction contracts may ask for unrealistic payment terms. Stalled or derailed projects may result in collateral that is worth less than the loan, presenting payment default risk. DCR provides stakeholders with security about viability and investment value, buoyed by ongoing budget and review by expert construction risk management consultants during the course of development prior to the loan commitment.

How a DCR Works

Document and Cost Reviews are not regulated by a uniform governing standard, so it is critical to engage with a reputable, knowledgeable firm with a diverse portfolio of project experience. A good DCR should entail a thorough, detailed, multi-point inspection of the proposed project details resulting from the support documents provided, drawings, contracts and varying due diligence reports.  Does the project include professional and liability insurance coverage (i.e. a bond)?  Does the project plan account for realistic budgeting and allowance for contingencies? Does the lender or institution understand due diligence or agency-specific reporting requirements? Finally, are there any voids in the budget that are not supported by the scope defined in the documents provided that may lead to red flag issues and problems that can arise on a construction project?

When engaging with a risk management firm, you may be asked to provide:

  • Construction documents such as, civil, landscaping architectural, mechanical, plumbing and electrical drawings, and project manual/specifications
  • Owner Contractor Agreement inclusive of all exhibits
  • Development and construction budget
  • Regulatory documentation (building permits, land-use, zoning, conditional approvals)
  • Other supporting documentation

DCR Fundamentals: Contract, Cost, Constructability, and Contingencies

Owner/Contractor Agreement
The contract between the owner (borrower) and contractor overseeing the construction project is the essential basis for setting and governing the practice for the entire scope of project, execution, delivery and funding. As such, the terms of this agreement should be feasible and balanced for all parties. Some of the biggest issues that can arise in a contract include: borrower commitment on the scope, scope exclusions and qualifications, achieving construction schedule milestones and completion, contractor administrative responsibilities, appropriate payment terms and timeline, and conformance with local agencies.

Other details that may be examined over the course of a DCR evaluation include (but are not limited to) whether the contract is standard or has customized language that may present risks, if bonding insurance is required, if it addresses key elements such as change order percentage, contractor’s fee, anticipated weather delays, unit costs, allowances, alternates, and shared cost savings.

Cost Analysis
80% of all construction defaults occur due to payment-related issues and delays. Because of this, it is critical to examine the overall project budget, as well as real-time market materials and labor costs, before beginning work. Will any/all of these be impacted by delays or unforeseen roadblocks? But a DCR may go even further in analyzing project funds. An appropriate payment draw schedule should match construction milestones or components that are evenly disbursed throughout the project stages – that is, not front-loaded. To reduce inappropriate expenditures, high overall allowance costs, cost overruns, or interest payment on funds not yet needed, contract cost breakdown may be examined line-by-line to compare the draw schedule to standard market practices and costs.

Feasibility of the proposed project within the budget and cross-disciplinary expertise provided is essential. Do the plans make sense architecturally, and with respect to engineering disciplines? Do the plan sheets provide a complete, up-to-date and adequate overview of the scope, establish equipment, material and finish specifics? Do the plans provide enough details about the design? Vague or lack of notes in the documentation can lead to misinterpretation by the GC or subcontractors, resulting in delays, change orders, or work that doesn’t meet the owner’s expectations. A DCR can uncover gaps in proposed work that may result in rework or excessive requests for information. Starting with the most complete agency approved, detailed, constructible plans can protect the project integrity in the long run.

All projects run into unexpected hiccups and unforeseen issues, and construction is no different. But if you set aside an allowance to account for these contingencies, they don’t have to derail the construction progress. Depending on whether the development is new or a renovation, there would typically be a 5 to 10% projected development budget allowance. Contractors may establish their own contingency, if overestimated, it might pad the GC’s profit, underestimate, it might lead to costly overruns, and a GC that might walk if the final costs are higher than what they can collect from the owner. You want to strike the right balance between a competitive bid and responsible planning.

A complex and fast-paced construction project has many moving parts and personnel that can present potential roadblocks to successful completion. However, a proactive pre-closing risk management plan, consisting of a Document and Cost Review of supported appropriate documents can help identify risks before beginning the project, and confirm project scope and budget are technically feasibility.