Financing construction projects can be a risky business for many reasons. Major risk to schedules and budgets are all too common – amounting to what can be a costly minefield for developers and in turn pose risks for construction lenders.
Add the problems stemming from the Covid pandemic, supply chain interruptions and increasing staff shortages being only the tip of the iceberg, it is now more important than ever to do rigorous financial, legal and bespoke construction related commercial due diligence to ensure lenders are fully aware of all risks relating to a project and are therefore in a position to properly underwrite it.
Monitoring The Construction Phase
Having made the decision to finance a project, the focus for lenders will then shift to the construction phase which will include the monitoring of progress by the lender’s third-party construction consultant. One of the key purposes of construction loan monitoring (CLM) is to identify potential construction-related potential problems at an early stage in order to allow issues to be resolved before they become major. CLM helps mitigate the risks inherent in construction lending such as poor contract language, insufficient contingencies, poor cost estimates, unrealistic schedules and insufficient insurance and bonding by the contractor. CLM also monitors construction phase risks like quality issues, schedule issues, overfunding for incomplete work and timing of funding to name a few. The CLM consultant will also review the timely payment of general and sub-contractors to avoid contractual disputes and liens being placed on the property for unpaid work. Lenders are highly unlikely to continue to fund a project where a mechanics lien trumps their security interest.
Identifying Risks Early
Being in the construction business, like many any other business, is about growing revenue and profit. Revenue and profit is why key stakeholders are involved in a construction project, such as the developer, general contractor, sub-contractors or at least those parties with “skin in the game”. The role of the CLM consultant in the past has been performed by quantity surveyors, project managers and project controllers which are typically deemed 3rd party independent consultants who have much less at stake. However, the role has developed into its own unique set of services. It’s not just about selecting a quantity surveyor or project manager for the role; it’s about choosing a CLM specialist who understands and can explain the construction-related risks to a lender on a construction project. Identifying risks to lenders and raising red flags early is critical. This can only be achieved by a strong monitoring role including physical site visits, correspondence analysis such as a schedule and budget reviews, payment application reviews and just having the experience to understand, from an abnormal sequence of events, what raises a red flag.
Due Diligence Is Critical
A skilled CLM consultant starts with a very strict set of due diligence tasks while the loan agreement is being drafted. A CLM consultant will require certain markers be met before the loan agreement is executed. All these requirements are presented to our lender team in the form of a detailed due diligence report and this usually happens just before the preconstruction process. Within the due diligence report, we use our expertise to analyze and comment on items that include but are not limited to: a developer’s project team, consultants, general contractor and major sub-contractors, budget and estimates (including contingencies and allowances) from the developer and general contractor, the form of the construction contract, insurances applied on the project, proposed construction schedule, development permit status and any subcontractor trade awards already procured. All this information then translates into a project risk section in which the CLM consultant will identify risks associated with schedule, budget, the construction team, environmental considerations, permits and any other general risks that may pose a threat to the project.
Monitoring The Project Lifecycle
Once the lender team is satisfied that all due-diligence checks have been made and the loan agreement executed, the role of the CLM runs through the pre-construction phase (design and procurement) to the construction phase and close out and typically ends when the loan is paid back in full. During pre-construction, constructability checks are made once each of the design stages have been achieved. Budgets and estimates are reviewed, and any major scope increases and overruns will be identified to the lender through the issuance of an updated due-diligence report. In a lot of cases the loan agreement is executed midway or near the end of the design phase so most of the pre-construction analysis gets identified during the due-diligence reporting stage of the loan agreement drafting. Each project is different, however.
Construction phase CLM is equally as important for lenders, because as the project moves through the cycles of trade specific buyout, budgets and schedule are tested against actual progress. The construction phase CLM role is identified by two integrated activities:
- CLM inspection: this involves a cost review of the monthly payment application to verify that all costs are in line with the draw requirements and progress of work is complete, that they are in line with draw requests, change order reviews and requests that have been met, as well as timeliness of payment. Technology now plays a bigger role than ever during the CLM inspections and can now include drones and handheld software on iPads.
- CLM reporting: this involves the submission of a monthly report after the CLM inspection for a particular month has been completed. The report includes, but is not limited to, cost checks, schedule reviews, risk analysis for any critical issues, contingency reviews, change order review and attachments of developer and contractor documents.
Selecting The Right CLM Partner
In summary, it’s imperative that lenders select the right CLM partner with the appropriate expertise, such as having knowledge of all national architectural and engineering firms and contractors, contractual understanding, labor supply, sub-markets, and trades. Sector experience is also critical because, for example, an airport has different requirements, specifications and project risks to say an office or residential tower. A CLM partner must have a proven track record of seeing projects through until loan closing. A national footprint is an advantage so the CLM work can be centralized. This saves time interviewing for new partners in new locations for every project .
As Seen In NAIOP’s Development Magazine, Summer 2022, “Reducing Financial Risks for the Lender on Projects”