Construction lending involves lenders loaning money to borrowers to fund their construction projects.
If not well managed, it may result in risks that may end up costing the parties involved, especially the lender.
Some construction lending risks are common across each construction loan program.
With a comprehensive risk management policy, such risks should be an issue. Below are common construction lending risks you should know about.
- 1 1. Failure to Complete the Project Within the Interim Construction Period Term
- 2 2. Little-to-no Contingency Budget
- 3 3. Ignoring Progress Reporting
- 4 4. Cost-plus Contracts Increase Default Risk
- 5 5. Incomplete or missing paperwork or project budget
- 6 6. Failure to Protect Your First Lien Right
- 7 7. Failure to Acquire Insurance
- 8 Endnote
1. Failure to Complete the Project Within the Interim Construction Period Term
If the budget isn’t properly managed, the funds may run out before the project is completed, making it risky for all concerned parties, especially the lender.
Correctly calculating and managing the construction loan holdback eliminates the risk of money running out.
This means that builders should never get more funds than the work they have completed, as indicated in the construction progress report, magnifying the importance of draw inspections and maintaining balance sheets until the project’s completion.
Consider outsourcing project inspection to market leaders such as Northwest Construction Control for honest and reliable reports regarding the construction project.
Additionally, the lender can ensure timely project completion by providing that the construction loan is always in balance, undisbursed funds remain sufficient to fund improvements, and draw disbursements are only released for completed work.
2. Little-to-no Contingency Budget
Considering the current market where material prices unexpectedly rise, it would be a good idea to have the contingency reserve added directly into the loan.
However, the borrower must qualify for the cost increase to build, and the property may have to appraise higher while the benefit cushions increase construction costs.
3. Ignoring Progress Reporting
Without progress reporting, budgets and timelines get out of hand.
Progress reporting ensures that the project is on schedule relative to the loan term and the completion time indicated in the construction loan agreement and contract.
Consider requesting progress reports every month regardless of whether there’s a draw application or not, ensuring timely completion.
Progress reporting helps you ascertain that workmanship and progress balance with funds requested by a draw application.
To manage loan risk, leverage professional inspectors to provide detailed inspection reports to prove that draw application requests align with the improvements made.
4. Cost-plus Contracts Increase Default Risk
Where a cost-plus contract controls a project, the borrower pays the contractor for the project costs and an allowance as profit.
Although these contracts aren’t illegal, they aren’t good for the lender. Since spending isn’t monitored during construction, the project’s final cost is undetermined.
To mitigate this risk, lenders must know the project’s cost, how the funds will be controlled, and whether work is progressing per the agreed project schedule.
5. Incomplete or missing paperwork or project budget
To mitigate this risk, lenders can themselves review the project in detail or enlist a qualified vendor to conduct the review before the loan closes, saving time and money in the long term by protecting you from construction contract-related litigation.
If the project budget isn’t correct, any unforeseen extra costs may increase default risk. If vital paperwork is incomplete or missing, the project may be delayed.
To perform the review, the lender should have the budget review, appraisal report, construction contract review, and permits.
6. Failure to Protect Your First Lien Right
Lien waivers ensure fair payment. They are a tool that protects a lender’s lien and avoids liens that delay or complicate construction projects.
Since construction lending comes with various property liens at different times, lenders should ensure they maintain their first lien position because lost lien priority leaves you at risk of losing your control over disbursement.
Getting lien documents right is key to mitigating risk.
This is why as best practice, you should ensure that waivers are completed in line with local and state regulations and that they’ve been completed on the right form and submitted on time.
Additionally, payment should only be given for completed work or materials in place.
7. Failure to Acquire Insurance
Before starting a construction project, it’s essential to take insurance cover to protect your financial needs in the event of any eventuality.
Insurance policies like builder’s risk insurance safeguard the property from fire, vandalism, theft, and natural disasters.
In contrast, the builder’s general liability protects the property from damage and physical and reputation-based injuries.
Construction lending is prone to several risks that might jeopardize your investment.
Familiarizing yourself with the potential risks you may face will help you prepare a risk management policy to safeguard your investment and rights.