Construction loans present unique circumstances for lenders.
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
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.
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.
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
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.
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.
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.
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.
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.
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.
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).
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.
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
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.
Solomon is Of Counsel at Foley and Lardner LLP where he focuses on real estate.
Contact him at email@example.com.