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How to Mitigate Construction Risks for Lenders

December 28, 2021

Construction lenders today are exercising more caution in financing real estate ventures. This is in part due to their memories of the great recession, as well as the recent trends impacting construction cost and labor markets. 

Developing a process to assess, mitigate, and manage construction risk, especially the internal risks of the construction team, can be an effective way to identify issues that need addressing before funding.

It’s also important to determine the main areas of risk and explain how lenders can minimize their exposure to risk in a construction project by working with an experienced construction consulting firm. 

Owner – Contractor Agreement

This document, if not reviewed properly, can be a major risk for the lender. The owner (the borrower of the funds) commits to a host of obligations that may not be in the lender’s best interest. To minimize risks, the lender should have someone well-versed in construction risk management carefully inspect the agreement to identify terms that may be detrimental to the lender. 

There are a few especially important parts of an agreement to scrutinize, including:

Contractor’s insurance

The contractor should be bonded and insured in accordance with the project’s value. Some contractors try to make their offer more enticing by offering inadequate insurance and bonding. It’s not uncommon for contractors to offer minimal insurance and no bonding for the project, which of course, exposes both the owner and the lender to huge risk if the contractor cannot complete the work.

Closely related to this, the lender should also review if the owner has purchased Builder’s Risk Insurance to manage any risk of loss or damage during construction.

Liquidated damages

Delays are costly and one way of controlling that kind of cost is to specify financial compensation for every day that the project remains incomplete. Of course, the completion date should also be set reasonably.

Construction schedule

The contract should require a baseline schedule plus monthly or regular updates based on Critical Path Method (CPM) practices. The baseline schedule should show logical relationships between tasks and dependencies. The owner-contractor agreement should include language that states schedule updates should show actual start and finish dates.

Payment agreement

A proper owner – contractor agreement will determine acceptable time frames for the lender to approve contractor’s draw requests. It’s not in the lender’s interest to hold up the schedule (main contractors generally pay the trades once they get paid themselves), but there are many steps to complete before a draw request can be reasonably funded. 

Apart from internal administration, the lender has to wait for their construction risk manager to verify that the work that is to be paid has really been completed and to get lien waivers from the subcontractors. In general, the most reasonable timeframe is around 30 days.

Storage for the construction materials

Major construction materials will often be purchased when the contract is signed to avoid price increases and budget blows. To ensure reasonable purchases, materials bought should be stored properly in a safe facility, which is also insured and bonded. Purchase documents should also be checked and the site inspected to verify that the materials are as described.

Weekly meeting attendance & site visits

Effective risk management of the construction project is impossible without some form of monitoring by professionals experienced in construction. Regardless of project delivery, a majority of active construction have a periodic status meeting, usually weekly. By having a lending representative at the table, they can learn important qualitative information such as how well the construction team is operating.

Additionally, inspecting the construction site is a good practice. Seeing the site, its progress, and the quality of work completed will make it easier to determine the validity of draw requests and identify red flags before they turn into a disaster.

On many large commercial projects, the owner or general contractor is employing construction technology such as in-progress drone flights and/or stationary time-lapse photos. This permits remote monitoring of the construction activities.

Quick response to draw requests

When a draw request is made, the lender’s representative should visit and inspect the site promptly. This is not only geared toward a better rapport with the owner and general contractor, but also to the timeliness of the project completion. 

Trade contractors are commonly paid only when the contractor has received payment. Therefore, approving and dispersing funds unjustifiably late increases the likelihood or exacerbates disputes that lead the subcontractors to slow progress or walk off the project.

Reviewing change orders

Change orders have to be closely scrutinized to ensure they are justified and reasonable. A change order should include a comparison on new costs and costs originally planned. Even though change orders cannot be completely avoided, when an experienced construction consulting company provides risk management services, the scope and number of change orders can be significantly reduced through diligent inspections, reviews, and documentation.

How can VERTEX help with construction lending risk management?

VERTEX is a team of highly experienced professionals from all fields of construction. We operate globally, including the U.S., Canada, and Mexico. Our consultants specialize in helping developers, lenders, and other stakeholders assess construction risks effectively, as well as help turn around delayed or troubled projects. Owing to our expertise and experience in the field, our clients count on us to resolve issues and guide their projects to completion.

Contact VERTEX today to find out more about our Construction and Real Estate Consulting services.

This article was originally published by Xpera Group which is now part of The Vertex Companies, LLC.

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