Nov 2015 Construction Loan Risk Mgt 1
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1 Richard Hamm, Principal, Advantage Consulting or Bill Tryon, Director of Strategic Development, Partner Engineering & Science Inc. or Dev Strischek, Senior Credit Policy Officer, SunTrust Bank or Nov 2015 Construction Loan Risk Mgt 1
2 Introductions Panel Questions Agenda 1-Setting up a real estate construction unit (RECAD) in a bank 2-Frequent construction problem causes 3-effective tools in RECAD preventive maintenance 4-RECAD s place in the organization chart 5-RECAD for owner-occupied (O-O) vs. real estate developer-investor (REDI) construction loans 6-RECAD training and skills 7-minimum size RECAD construction loan 8-RECAD and HV-CRE Closing & Summary Q&A with audience Resources & References and Appendix Nov 2015 Construction Loan Risk Mgt 2
3 1-Both of you have managed real estate construction administration (RECAD) units in your banking careers. If you were asked to set up a new RECAD unit, what would the first 2 or 3 actions you would take? Richard Hamm 1-Assess the experience level of potential staff in terms of project types and sizes 2-Develop at least two levels of monitoring intensity, based on portfolio size and the inevitable 80/20 rule 3-Set-up lunch & learn sessions with key providers, such as title company and surveyor Bill Tryon 1-Review the institution s strategic plan 2-Assure separation of the unit from lending 3-Establish construction loan administration and disbursement procedures See App C: Four Steps of Construction Rsk Mgt Nov 2015 Construction Loan Risk Mgt 3
4 2-Each of you has seen your share of problem construction loans. What have you experienced as the 2 or 3 most frequent causes of problem construction loans? Bill Tryon 1-Inadequate budgets, frequently based on preliminary plans 2-Unexpected conditions, particularly relative to subsurface and environmental conditions 3-Lack of appropriate mechanisms to control discretionary changes See App A: Causes of Project Failure Richard Hamm 1-Lack of payment and performance bond for material size level 2-Admin staff in checklist mode 3-Lack of inspections, both random and in minimum time intervals, regardless of a draw request Nov 2015 Construction Loan Risk Mgt 4
5 3-What have you found to be your 2 or 3 most effective tools or techniques in RECAD preventive maintenance? Richard Hamm 1-More than a formula for testing interest reserve for material credits 2-Having at least two levels of monitoring so that common sense can be used for material credits 3-Having a clear way to report concerns to the line or credit team Bill Tryon 1-Independent, critical evaluation before and during the loan 2-Proactive construction loan administration 3-On-going critical and informed project monitoring See App B: Effective Techniques for Preventing Problems Nov 2015 Construction Loan Risk Mgt 5
6 4-How do you organize a RECAD department? To whom in the organization do you think it should report? Bill Tryon How to organize The specific organization is less critical than the capabilities and independence of staff. All staff should receive appropriate training and oversight. Where to report Reporting should be independent of loan production, ideally to a senior credit officer Richard Hamm How to organize It should be as independent as possible At least a lending support person that has dotted line to credit admin Where to report Report to chief credit officer, if possible NEVER to the lenders See App D: Construction Risk Management Issues Nov 2015 Construction Loan Risk Mgt 6
7 5- What do you view as the 2 or 3 significant differences in administering construction loans for owner-occupied (O-O) projects vs. real estate developer-investor (REDI) projects? Richard Hamm 1-Customer wanting to be his/her own GC 2-Not understanding that change orders are hidden profit for GC/subs 3-Unusual interior or exterior finish/design that affects market value of property See App E: Types of Commercial Construction Projects Bill Tryon 1-Tend to be less sophisticated as developers, and more prone to make discretionary changes without regard for budget. As a result they require more oversight and assistance to stay on track. 2-The property tends to be more critical to their business success, so may be less likely to default. Nov 2015 Construction Loan Risk Mgt 7
8 6-What kind of training and skills do you look for in staffing a RECAD department? Bill Tryon Training Process, process, process Legal requirements Construction management Skills Driven by details Critical thinking Understanding of big-picture risks Richard Hamm Training Skills Not so much on credit issues More on fundamentals of title policies, surveys, etc. RMA course!!!!!! Organized Not afraid to get clear answers from customer See App E: Types of Commercial Construction Loan Projects Nov 2015 Construction Loan Risk Mgt 8
9 7- A RECAD department is expensive to set up and operate. What 2 or 3 factors would you consider in calculating a minimum size construction loan to be managed by RECAD? Richard Hamm 1-CRE portfolio s 80/20=rule point 2-Loan system capabilities, or existing automation of the process 3-Bank size to enable an independent function [$750 million++??] Bill Tryon 1-Bank strategy and risk tolerance 2-Client and project type 3-Staffing constraints 4-Competetive practices See App F: Minimum Construction Loan Size Nov 2015 Construction Loan Risk Mgt 9
10 8-High Volatility CRE (HVCRE) puts a hefty 150% premium on construction loans. What 2 or 3 actions would you suggest that RECAD units take to minimize the impact of HVCRE on a bank s capital? Bill Tryon 1-Don t deviate from exceptions to HVCRE rules Observe LTV requirements Assure borrower contribution of > 15% of the as-completed value before advancing funds Require borrower contributed capital to remain in the project until permanent funding. Richard Hamm 1-Ensure accurate reporting of actual loan outstandings on loan system and management reporting 2-Note where equity position of project changes, postapproval 3-Minimize any further exceptions to policy See App G-1: Basel III s HVCRE Rule and App G-2: HVCRE Calculation Nov 2015 Construction Loan Risk Mgt 10
11 9-Any best practices you would like to share? Richard Hamm 1. RECAD field trips to projects 2. Approved contractor list 3. Awareness of take-out prerequisites Bill Tryon 1. Keep origination & control function separate 2. Develop scopes of work and processes that reflect your risk tolerance 3. Don t assume supervision by syndication lead bank satisfies your risk tolerance 4. Consult with peers Nov 2015 Construction Loan Risk Mgt 11
12 Closing remarks Closing and Summary Setting up a RECAD unit Frequent causes of construction problems RECAD preventive maintenance tools RECAD in organization chart O-O vs REDI in RECAD RECAD training & skills Right size RECAD construction loan RECAD and HV-CRE Questions and answers Nov 2015 Construction Loan Risk Mgt 12
13 CRE = commercial real estate HVCRE = High volatility CRE O-O = owner-occupied RE = real estate RECAD = real estate credit administration REDI = real estate developer/ investor Glossary Nov 2015 Construction Loan Risk Mgt 13
14 Resources and References Analyzing Construction Contractors, RMA Course. See for details. Ed Beasley, Construction Lending in Recessionary Times, RMA Journal, June 2009, pp Joey Bonin, Construction Lending Risk: Management That Knows No Bonds, RMA Journal, June 2014, pp Construction Loan Management: Administering the Construction Loan Process, RMA Course. See for details. Frank DiLorenzo, The Construction Loan Agreement: The Key to the Construction Loan Process, Part 1, RMA Journal, Nov 2006, pp ; The Construction Loan Agreement: Use of Proceeds, Part 2, RMA Journal, Dec 2006-Jan 2007, pp ; The Construction Loan Agreement: Safety in Clarity, Part 3 RMA Journal, Feb 2007, pp Robert Fuhr and Keith Schlemlein, Reduce Risk with Rigorous Construction Loan Inspection and Disbursement, RMA Journal, Nov 2010, pp Richard Hamm, Construction Loan Administration: Managing Risk in Commercial Projects, RMA Journal, April 2007, pp Marla McIntyre and Dev Strischek, Mitigating Real Estate Construction Risk: How Surety Bonds Protect Borrowers and Bankers, RMA Journal, November 2005, pp Marla McIntyre and Dev Strischek, Our Letters Are Not Their Bonds: The Difference between a Bank Letter of Credit and a Surety Bond, RMA Journal, February 2006, pp OCC Commercial Real Estate Lending, August 2013, OCC Other Real Estate Owned, September 2013, Preventing Black Swans: Avoiding Major Project Failure, Derek Pollard, Who s on First? You Are! RMA Journal, May 2012, pp Policy Statement on Prudent Commercial Real Estate Loan Workouts, OCC, October 30, 2009, Marc Ramsey, Surety Bond Producers and Underwriters Play Key Role in Construction, RMA Journal, May 2009, pp Bob Scales, Close and Continuous Monitoring of Construction Projects Can Prevent Headaches for Lenders, RMA Journal, Sept 2008, pp Dev Strischek, Analyzing Construction Contractors, Third Edition, Risk Management Association: Philadelphia, Brian Ward, Building a Platform for Construction Risk, RMA Journal, pp Nov 2015 Construction Loan Risk Mgt 14
15 Appendices App A: Causes of Project Failure App B: Effective Techniques for Detecting Problems App C: Four Steps of Construction Rsk Mgt App D: Construction Risk Management Issues App E: Types of Commercial Construction Projects App F: Minimum Construction Loan Size App G-1: Basel III s HVCRE Rule App G-2: HVCRE Calculation Nov 2015 Construction Loan Risk Mgt 15
16 App A: Causes of Project Failure Inadequate budgets Contracts based on incomplete designs Discretionary changes Inadequate management of project revisions Unforeseen conditions Inexperienced project team members Inadequate project oversight and coordination Unrealistic schedules Resource shortages Completion delays Misdirection of funds/resources Nov 2015 Construction Loan Risk Mgt 16
17 App B: Effective Techniques for Preventing Problems Before the loan: Critical review of construction documents Reconciliation of plans with the appraisal, survey, geotechnical reports, zoning approvals, etc. Evaluation of the developer and contractor teams Careful documentation of funding requirements Verification of government approvals and availability of utilities Require a completion bond or construction commitment After the loan: Utilize appropriate loan administration and disbursement controls Insulate loan administration from the origination function Independent critical assessment of construction progress and pay applications Critical review of disbursement requests Periodic attendance at job-site meetings Monitoring of lien status Limited release of contingency funds ahead of the percentage of completion Active oversight by the development team Nov 2015 Construction Loan Risk Mgt 17
18 App C: Four Steps of Construction Rsk Mgt Construction risk management Definition Elements Four Steps in managing construction risk Determine type of construction Create construction loan agreement Ensure permanent take-out loan is in place to close out construction loan Monitor and manage construction loan portfolio Nov 2015 Construction Loan Risk Mgt 18
19 App D: Construction Rsk Mgt Issues Up to date construction risk management policy Meeting internal demands for fast turnaround times Balancing risk management with pressure to stay competitive Doing more with smaller staff In-house vs. outsourced functions Nov 2015 Construction Loan Risk Mgt 19
20 App E: Types of Commercial Construction New construction Repairs Deferred maintenance Renovations and tenant improvements Projects Nov 2015 Construction Loan Risk Mgt 20
21 App F: Minimum Construction Loan Size RECAD resources Complexity of project In-market vs. out of market Nov 2015 Construction Loan Risk Mgt 21
22 App G-1: Basel III s HVCRE Rule Basics of Rule HVCRE defined as all ADC CRE loans except 1-4 family residential loans, or CRE ADC loans that Meet applicable regulatory LTV requirements (see App C: FDICIA Supervisory LTV Ratios) Borrower has Contributed cash equity > 15% of property s appraised as completed value before bank s initial funding, and Contractually agreed that contributed capital remains in project until credit facility is taken out by permanent financing, sold, or paid in full HVCRE loans risk-weighted 150% vs. current 100% HVCRE does not apply to Purchase or development of ag land if its valuation is limited to ag use ADC loans for community development investments Owner-occupied permanent financing So a CRE loan not classified as HVCRE is treated as corporate exposure Nov 2015 Construction Loan Risk Mgt 22
23 App G-2: HVCRE Calculation Total ADC Loans Less: 1-4 family residential properties Less: Ag purpose properties Less: Community development loans Less: ADC loans that meet criteria on previous slide HVCRE Loans at 150% Risk Weight Nov 2015 Construction Loan Risk Mgt 23
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