Commercial construction lending is on the rise. As the economy steadily
improves, more commercial projects are either in the works or being planned.
Whether it is multifamily construction, such as condominiums or apartment
construction, or retail and office space, lenders have to approach each
new loan application with a unique set of approval and underwriting criteria.
Just as every project is unique in its planning and construction, each
commercial loan will have to be structured to fit the financing goals
of that development. While there are standard underwriting guidelines
a lender follows, additional tasks must be identified and completed to
help ensure a successful transaction.
Real Estate Pro Forma
Banks assume the risk associated with the developer’s ability to
complete a project on time and within the proposed budget. A credible
pro forma, which is merely the projected income of the business, is key
to assisting the lender in determining if a project is feasible, based
on the lender’s knowledge of the market and the income and expenses
of similar properties. If the construction costs are too close to the
expected income of the project, it is a strong indicator the project will
not be feasible and may be declined for financing.
Plans and Budget
The construction budget and pro forma are both critical elements in determining
project viability. The owner/builder should present a detailed line-item
budget that will be reviewed in underwriting to determine if it is reasonable.
Construction budgets should include both hard and soft costs.
Hard costs will consist of items related to construction and other reasonable
expenses incurred in the build-out of the project. These costs also encompass
general contractor's fees and other costs, including contract items
such as bonding and construction insurance.
Soft costs include interest, fees, and other predevelopment costs. Soft
costs also include a contingency account that must be contained in the
budget to protect against unanticipated overruns. Costs payable to third-parties
may include developer fees, leasing expenses, brokerage commissions, and
management fees. These charges, if reasonable, may be contained in the
The lender should review the budget to determine whether the project can
realistically be completed as presented and how it compares to other recent
projects of similar properties in the market. Lenders should be cautious
of developers that submit budgets which either lack the necessary details
or which appear overly optimistic. An experienced lender will rely on
their expertise to recognize inaccurate budgets that could lead to excessive
cost overruns, excessive change orders, and the eventual need to advance
additional funds to complete the project. To the degree a lender does
not feel it has adequate expertise in construction lending, or construction
management in the desired marketplace, the lender is well advised to seek
outside consulting parties to confirm the budget is realistic given market
conditions such as local cost of labor, materials and delays due to any
local government regulation.
The primary purpose of commercial construction is to create a profit for
both the lender, the borrower, and the developer if different than the
borrower. If the project’s budget allows little or no profit for
the developer, there will also be no room for overruns, and it increases
the chance the lender will have to take possession of an unfinished project.
Additionally, the lack of available profit will complicate the lender’s
ability to attract a prospective purchaser after completion. If this occurs,
it may require the lender to dispose of the property at a loss.
The budget does not only need to be realistic as an overall plan, but lenders
also need to examine each stage of the development carefully and should
be aware of the practice of front-loading. Front loading is when a builder
deliberately overstates the cost of the early stages of construction.
When this occurs, and if the lender does not detect it at the beginning
of the process, there will likely be insufficient funds to complete construction
if there is a default.
Lenders need to monitor the progress of the developments they finance to
ensure adequate funds remain to complete the projects. Obtaining regular
reports and conducting site visits can help detect potential problems
early. Although the budget should include an allotted amount for contingencies,
they are intended for reasonable but unexpected increases in costs that
can occur for a variety of reasons. Since some projects can take several
years, it is not uncommon to experience increases in the cost of materials
or overtime pay due to delays of shipments or adverse construction conditions.
However, there are a few additional issues that can pose a serious threat
to project completion.
• Liens filed by contractors, subcontractors, or material suppliers
- Governmental interference and general NIMBY considerations.
• Failure of the contractor or a subcontractor to complete construction
• Excessive cost overruns.
While some risks are beyond the control of either the lender or the contractor,
many can be mitigated through careful analysis of the plans and budget
as well as routine inspections. Regardless of the borrower, the lender
should ensure the developer has sufficient expertise in their project
and that the development is progressing as anticipated.
A Change in Plans
Quite often, change orders come up due to materials being no longer readily
available, detrimental increases in costs resulting in using alternate
suppliers or subcontractors, or any number of other reasons. Lenders need
to have a skilled staff to monitor change orders and may elect to hire
an outside consulting firm to review and give the recommendation of whether
to approve changes. A significant number of change orders could indicate
deeper issues with the project. Regardless of the number of change orders
that may transpire, the loan must stay in balance.
Commercial Construction Loan Files
In addition to the project plans, feasibility study, and executed construction
contracts and budget, a commercial construction loan file must contain
a detailed loan agreement, which describes the rights and obligations
of both lender and borrower. It should also cover the conditions for advancing
any funds and the repayment criteria. The agreement must provide a provision
to support the lender if the loan goes into default. The agreement ought
to include a full budget, recognizing all costs funded by the construction loan.
The file must include a foundation survey that is completed after the foundation
has been completed and before proceeding with additional work, to ensure
it is consistent with the site plan and not encroaching on easements or
other properties. Furthermore, all appraisals estimating the market value
of the property before, during, and after completion should be included
as well. Stabilization of occupancy should be predetermined and the file
ought to reflect when stabilized occupancy is expected to be achieved.
These documents, when reviewed and compared to the project's timeline
and budget, will assist the lender in detecting any potential problems early.
Lenders and developers need to set clear guidelines and expectations for
both parties to the contract, and what constitutes a breach. The bank
depends on the success of the project to earn a profit and does not want
the developer to default. It is through scrutiny over the proposed budget
and a meticulous monitoring progress throughout the various phases of
construction that the bank can minimize their risks in the highly specialized
field of commercial construction loans.
Contact Geraci Law Firm at (949) 298-8050 today, or contact NemaDaghbandan
for more information.