Structure your project documents to mitigate risk before approaching lenders.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.