Financing Focus

Construction Plans

Structure your project documents to mitigate risk before approaching lenders.

Sponsors and owners considering financing the construction of commercial real estate projects need to know how lenders evaluate a project's overall risk. Such understanding increases the likelihood that a developer's application for financing will be approved.

Lenders view construction loans as inherently riskier than conventional commercial real estate loans. While conventional loans are supported by cash flow-generating real property, construction loans generally are secured by unfinished collateral and speculation as to the completed project's economic viability. Managing basic construction risks from both the lender's and sponsor's perspective begins as early as the project's planning phase.

Common Concerns
To mitigate some of the general construction risks, lenders may require certain terms and provisions be incorporated into the construction documentation and also may include corresponding terms and provisions in the loan documentation. Although every project is different and has its own set of issues, the following scenarios focus on some common concerns.

Failure to complete a project on time can result from material or labor shortages; failure of a major supplier, contractor, or subcontractor to deliver goods and services; substandard work that must be redone; contractors or suppliers with competing projects and commitments; or casualty and/or weather-related delays.

All of the above factors, which contribute to schedule delays, also can result in cost overruns. In addition change orders, material price increases, the need to pay overtime, or poor job estimating can cause a project to be over budget.

Filing of liens against the property or contractors failing to complete the project often result from labor disputes among material suppliers and/or subcontractors and the general contractor or the owner.

Reducing Risk
Lenders mitigate many of the foregoing risks through careful negotiation of the construction documents. The following list covers some standard and not-so-standard terms of construction contracts, their significance, and how such terms can increase or mitigate risk.

Contract Time. The contract time is measured from the date a project begins to its substantial completion. Failure to achieve substantial completion by the time specified in the contract can result in overtime charges or other penalties. The reasonableness of the time allotted for substantial completion should be assessed carefully. The contract can provide a schedule that permits the monitoring of construction progress. The contract also should build in reasonable force majeure extensions. The construction schedule and force majeure rights should be mirrored in the other contracts (as applicable) and in the construction loan documentation. A project that is not completed on time also may void any commitment for permanent takeout financing. Contracts may include financial disincentives when it comes to schedule delays.

Contract Sum. The contract sum is the total cost of a construction project. The architect should carefully review the schedule of values for appropriateness and reasonableness of cost and comprehensiveness. A contract that is not detailed or specific enough to cover the costs for every aspect of a project runs the risk of exceeding the budget, as these costs will have to be negotiated and factored in after construction has begun.

Other terms, such as penalties for late payments, charges for change orders or modifications, and escape clauses inserted by contractors, may be unfavorable to owners. Front-loading, whereby a builder deliberately overstates the cost of work to be completed in the early stages of construction, increases the likelihood that there will be insufficient loan funds to complete the project if there is a loan default.

A cap on change orders and a cap on the contract sum ensure that a project does not exceed the construction budget. Retainages, typically 10 percent of the cost of the work and materials, and contingencies, also 10 percent, are effective tools to manage cost overruns and delays as well. Once again, the loan document provisions and the various construction contracts should reflect change order and retainage provisions.

Assignability and Ownership of Plans. Lenders prefer contracts that are freely assignable. In the event of a default by the owner/borrower under the loan, the lender wants the ability to "step into the shoes" of the owner and have the contractor or a surety complete the project. In the agreements with the project architect, engineers, and the general contractor, owners should retain ownership of the plans, specifications, and drawings so that another contractor or the lender may complete the project if necessary.

Dispute Resolution. The owner and contractor usually have a choice of arbitration, mediation, or trial in the event of an unresolved dispute. Although arbitration is favored for small disputes, generally, the larger and more complex the project, the less advantageous it may be. Some people believe that contracts are more likely to be enforced in court as opposed to arbitration.

Subsurface Conditions. One of the main causes of delays and cost overruns is the existence of adverse subsurface conditions. Contracts should provide that if a contractor encounters subsurface conditions that are materially different from those contemplated in the contract or those that can be reasonably expected, a contractor is entitled to an equitable adjustment in the contract. Lenders often expect that subsurface work will be performed or conditions fully analyzed before agreeing to proceed with funding.

Architect Responsibilities. Construction contracts should include terms that require architects or their representatives to be on site during construction or to make periodic on-site inspections of the work. Their presence and periodic inspections help to ensure that any problems with workmanship or materials are detected early, thereby allowing for modifications to the work without significant disruption to the schedule or overall budget. In addition, architects, not owners, should be in direct contract with all the necessary consultants including structural engineers and design professionals.

Guaranty of Contractors. Under a performance bond, a surety guarantees that the construction contract will be performed in the event of a contractor default. Although bonds have their own limitations and challenges, contracts that require them provide owners and lenders with additional security that in the event of a contractor default, owners still may have the project completed.

This broad overview of certain terms found in a construction contract illustrates how these terms distribute the common risks associated with commercial construction projects. It is important to recognize that many such risks, through careful negotiation of the construction and loan documents, can be addressed and thus mitigated.

Peter J. Korda, JD, and Evangeline M. Chan, JD

Peter J. Korda, JD, is a partner in the real estate finance practice group at Seyfarth Shaw LLP in New York. Contact him at (212) 218-5260 or pkorda@seyfarth.com. Evangeline M. Chan, JD, is an associate in the real estate practice group at Seyfarth Shaw LLP in New York. Contact her at (212) 218-3388 or echan@seyfarth.com.

Recommended

Knowing the Lease

Nov.Dec.19

Understanding who is paying for what can help improve communication between real estate pros and clients.

Read More

Learning from Experience

Sept.Oct.19

Opportunity zones have plenty of potential, so here are lessons to be learned from the industry’s experience with EB-5 visas.

Read More

Knowing the Negative

July.Aug.19

While the intricacies can seem boring and irrelevant at times, understanding the effects of both positive and negative leverage environments on cash-on-cash returns is essential. 

Read More

FHA to the Rescue

May.June.19

While typical FHA loans range between the tens of thousands and hundreds of thousands, many FHA borrowers are also using these programs to finance projects over $100 million.

Read More