CONSTRUCTION LENDING RISK

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1 CREDITRISK CONSTRUCTION LENDING RISK MANAGEMENT THAT KNOWS NO BONDS Performance and payment (P&P) bonds have been the traditional way to manage construction lending risk. But compelling alternatives that are proactive in nature are gaining popularity in the industry and approval by regulators. 14 June 2014 The RMA Journal

2 June 2014 The RMA Journal 15

3 The U.S. Department of Agriculture, the U.S. Department of Housing and Urban Development, and many commercial-construction financing programs acknowledge these bond-alternative services as an appropriate approach to managing construction risk. BY JOSEPH BONIN An improving economy has meant a marked upturn in commercial construction. But with that greater opportunity comes greater risk: Increased regulatory governance and the tighter credit climate accompanying the recovery have combined to make risk management in construction lending an even greater priority. Given the commercial real estate losses during the Great Recession, lenders are particularly sensitive to construction financing risk in this rebound. The Rise of the Bond Alternative Performance and payment (P&P) bonds have traditionally been the most common method of managing risk in construction lending. But alternative and additional measures are increasingly popular. Although implementation of these measures is not consistent across the industry, they are widely recognized as good practice by various regulatory and government agencies. The OCC s Commercial Real Estate Lending handbook was updated in 2013 to better reflect the current state of play and now provides far more comprehensive guidance for construction loan procedures and risk management policies. According to the handbook, the following practices will allow lenders to proactively manage and mitigate risks: Careful scrutiny of the plans and budget by a qualified individual. Frequent and routine inspections, including inspection reports by architects or engineers who are independent of the borrower. Thorough investigations of the financial condition and reputation of the borrower, contractor, and subcontractors. Use of effective loan administration procedures. The handbook recommends the use of third-party engineering or architectural firms, adding that P&P bonds can help mitigate risk further. And while the Small Business Administration s Standard Operating Procedures says if the construction component is more than $350,000 [the] lender must obtain evidence that the contractor has furnished a 100% performance and labor and materials payment bond, it also states that the SBA has granted a blanket waiver on the requirement of a performance bond when a third party in the business of providing construction management services controls the disbursement of the proceeds. 1 That section in the SBA s policy has given rise to the term bond alternative to describe the suite of services offered by third-party engineering firms. Most particularly, this term refers to the funds control/disbursement component, but it also describes financial and engineering services that include the contractor evaluation, document and cost review, and construction progress monitoring. The U.S. Department of Agriculture, the U.S. Department of Housing and Urban Development, and many commercial-construction financing programs acknowledge these bond-alternative services as an appropriate approach to managing construction risk. Still, many lenders are not familiar with their particulars. Let s look at the most common alternatives to P&P bonds and how they can minimize loss. Construction Risk Management Tools The first tool used during underwriting is a document and cost review also known as an initial plan review or pre-construction cost review. It brings scrutiny to project plans and specifications. The analyst will evaluate the project s budget, schedule of values, and scope of work as well as the owner/contractor agreement and any other relevant documents to determine project viability. This pre-construction service verifies whether the project can be built within the anticipated budget, schedule, and funds allocation presented by the general contractor. Often concurrently, the provider will underwrite the abilities and capabilities of the general contractor (GC) a process known as contractor evaluation, contractor underwriting, or general contractor analysis. The lender normally PREVIOUS SPREAD: istock/thinkstock This page: Stockbyte/Thinkstoc 16 June 2014 The RMA Journal Copyright 2014 by RMA

4 underwrites the borrower or loan at hand, and the document and cost review determines project constructability. Without evaluation of the contractor, no one would be underwriting the GC, one of the most important entities of the construction process. The evaluation provides an in-depth review of the qualifications, capabilities, and abilities of the GC to complete the project. To complete the evaluation, the contractor is required to provide key company documents and information such as recent and current projects, standard project-management procedures, equipment owned, safety program information, financial statements, and the general contractor s license. Construction progress monitoring, also known as a draw inspection, consists of frequent and routine site inspections throughout the project to independently verify that construction progress is consistent with the funds requested from the contractor. Site observations are conducted in conjunction with each draw request to determine percentage completion by line item. The inspector should monitor the progress of construction, assess conformance with the provisions of the construction loan agreement, address work hindrances, and track and process 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. In addition to the services mentioned, a lender may use a completion commitment to further mitigate the risk of construction loans. For a fee, usually 50 basis points of the total hard construction budget, the provider will in the event of contractor default or termination step in to complete the project as specified in the original plans and loan approval documents. Generally, this option must be selected along with June 2014 The RMA Journal 17

5 all of the previously mentioned risk management tools prior to the start of the project. This is because the most important part of the completion commitment is the proactive nature of these combined services: It is designed to prevent a crisis and/or to have a third party parachute in at the first sign of a crisis to correct the course. Generally, a lender would not select the completion commitment if it will require a P&P bond. It would be used as an alternative. How P&P Bonds Work Performance and payment bonds, the principles of which have been around since 2750 B.C., 2 are commonly used in the construction industry by those seeking financial protection from defaulted projects. If a contractor is unable or unwilling to pay project bills or perform work, a P&P bond typically calls for the surety company to step into the shoes of the contractor to pay the bills and complete the project. Contrary to popular belief, the P&P bond is not a comprehensive form of insurance that covers all projects over a fixed period of time. Instead, the bond is linked to a specific project and a specific amount of money. The coverage ends once the project is completed, and additional bonds must be purchased for each subsequent project. While the new OCC handbook states that in addition to the aforementioned practices P&P bonds can further mitigate construction risk, many (often smaller) lenders rely exclusively on bonds. Weighing Your Options Depending on the institution s risk tolerance, a lender may choose between a bond or a bond alternative, use just a few of these tools in a piecemeal fashion, or opt to use none at all. Discussions at Partner Engineering and Science Inc. s recent Construction Lenders Risk Management Round Table in Phoenix indicated that the approach to construction istock/thinkstock 18 June 2014 The RMA Journal

6 A comprehensive bond-alternative program allows for early identification of problems and for corrective measures to be taken. risk management varies greatly. Some lenders incorporate only basic underwriting functions, or a credit score at best, into their lending practices. Others implement a far more comprehensive suite of risk management tools document and cost reviews, contractor evaluations, construction progress monitoring, funds control/disbursement, completion commitments, and/or performance and payment bonds to help mitigate losses and meet regulations. A survey of round table participants found that 95% of the attendees policies had been updated in the last five years. More than half indicated that a need for proactive construction risk management policies was the impetus for change. When determining the appropriate level of risk management, it is important to consider the approach (proactive versus reactive), suitability for the particular project, and cost. What distinguishes the bond-alternative process as well as a completion commitment from P&P bonds is that bonds are generally reactive instruments that are relied on in the event of a default. A comprehensive bondalternative program allows for early identification of problems and for corrective measures to be taken proactively throughout the construction process to help prevent a default. For a $10 million 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 bond-alternative program fee would be around $45,000 and include the contractor evaluation, document and cost review, construction progress monitoring, and funds control/disbursement. Including the additional completion commitment would add around $50,000 to the total fee. While bonds have long provided satisfactory coverage for many lenders, not all projects qualify for them. Projects that cannot be bonded or will have difficulty obtaining a bond include the following: Churches, temples, synagogues, and other houses of worship. Projects where the owners and the contractor are one and the same. Projects with foreign ownership. Projects with groundwater contamination. Newly established contractors may also be unable to qualify for bonding because of their lack of experience. For smaller contractors with limited resources, a bond-alternative program can be used as an outsourced accounting backroom, usually at no cost to them because the borrower pays the fee. In all these instances, the program offers an effective alternative to protect against potential losses. v Joseph (Joey) Bonin is a principal and national client manager at Partner Engineering and Science Inc., a national full-service engineering, environmental, and energy consulting and design firm. He can be reached at Notes 1. See SBA SOP (F) (effective January 1, 2014) Subpart B, VI. Construction Loan Provisions (13 CFR ), pp , available at 2. See Jeffrey S. Russell, Surety Bonds for Construction Contracts, ASCE Press, June 2014 The RMA Journal 19

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