Financing Focus

Seeking Balance

Construction loans present unique circumstances for lenders.

By Joel C. Solomon |

As the economy recovers from the Great Recession, construction lending is slowly resuming its place as an important component of real estate lending. For example, in Chicago, there has been a flurry of multifamily developments, and currently two major office projects are under way. And in secondary markets such as Cleveland and Kansas City, entrepreneurial developers are undertaking challenging adaptive reuses by converting vintage office buildings into hotels and condominiums. Clearly construction has returned and with it, the construction loan.

Apart from the many nuances of the different product types, a construction loan is unique because the loan is for something that does not yet exist. The developer must create a cogent business plan that will withstand a lender’s underwriting. The lender must negotiate big-picture loan terms with the borrower and underwrite the feasibility of the ultimate project and its economic value.

By the time a loan closes, the lender and the developer have typically finalized many critical-path items including an agreed-upon budget. The loan agreement will require post-closing lender approvals for anything not final at closing. Therefore, if the basic plans of the project are in place but key items such as finish standards are not finalized, lender approval must be required as a funding condition. Other funding hurdles, such as orderly draw requests with lien waivers and architect’s sign-offs, help the lender control the process.

Notwithstanding its approval rights, a lender is contractually obligated to fund the loan provided the borrower is in compliance with the loan agreement conditions. Recently, a California jury reached a $39 million verdict against East West Bank, finding the bank breached its construction loan agreement. That action forced the family-owned developer to default on the loan, which eventually led to foreclosure.

Change Orders

Change orders are part of the construction process, and they occur for a number of reasons, including overly aggressive contractor bids, inefficiencies in design/build projects, material cost increases, cost estimates that prove to be wrong, and developer or end-user requested changes.

Change orders usually mean increased costs and the risk that the project could go over budget. Change orders may also reduce the costs of the project through value engineering with either seen — the lobby or pool build-out — or unseen — the heating and air conditioning system — changes.

Loan-in-Balance Provisions

The ultimate protection for a lender is the requirement that the loan remain “in balance,” meaning that the unfunded loan is sufficient to complete the project.

The budget expresses the project’s cost. It accounts for everything required to transition from concept to finished project, including leasing costs and operating deficits for multifamily projects; marketing costs for condominium projects; tenant improvement costs and leasing commissions for office projects; and furniture, fixtures, and equipment costs for hotel developments.

To the extent that change orders increase the overall cost, reallocating savings from other line items or contingencies provides the borrower flexibility. Soft cost contingencies are for overruns from expenses such as fees for architects and engineers, building permits, and utility access; real estate taxes; leasing commissions; and sales and marketing costs.

Even with reallocations of line item savings and contingencies, it is always possible that change orders or erroneous budget assumptions create concern that the undisbursed loan proceeds will not be sufficient to complete the project and pay off the borrower’s obligations. If that occurs, a lender relies on the right to declare a loan “out of balance.” Effectively, the lender can declare a default based on its conclusion that the undisbursed loan will not be sufficient to complete the project.

An ideal loan-in-balance provision provides that the loan shall be in balance only when the available source of funds equals or exceeds the lender’s estimate of remaining costs (a global budget analysis) and each budget line item is sufficient to pay the costs of the line item (a line item analysis).

Because the lender needs to rely on firm, defensible criteria before asserting that a loan is out of balance, the available source of funds should incorporate the remaining unfunded loan, the unfunded contingencies — to the extent available — upgrade deposits, tax deposits, and any other sources of funds for the borrower. The definition of “lender’s estimate of remaining costs” should contain objective criteria that a reasonable lender may rely on to determine what remains unpaid. Suggested factors include pending and expected change orders, contractor or supplier claims for additional amounts, and the effect of anticipated or actual delays.

A declaration of out-of-balance default allows a lender to institute default rate interest and stop funding. Such remedies clearly create a make-or-break situation for a borrower/developer. The lender must be in a fully defensible position by having objective evidence if it seeks to declare an out-of-balance default.

Developers and lenders are aligned in the goal of a successful project delivered on time and within budget. Reasonable approval rights account for the evolving nature of a construction loan. A well-developed budget and objective criteria governing its use provide for the possibility that a complex plan does not proceed exactly as the original budget anticipated.

Joel C. Solomon is Of Counsel at Foley and Lardner LLP where he focuses on real estate. Contact him at jsolomon@foley.com.