5 Common Construction Lending Risks

Ravindra Ambegaonkar
Author : Ravindra Ambegaonkar
September 15, 2021
2 Minutes Read
  
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    Key Takeaways :

    • Construction lending risks can be costly if not well managed. When a lender is well aware of the risks involved in construction lending, they can identify them on time and develop strategies to mitigate them before anything goes wrong.

    • The lender should ensure that the construction loan is always in balance, the undisbursed funds stay sufficient to complete improvements, and draw disbursements are only released for completed work.

    • To reduce this risk, lenders should consider performing detailed project reviews themselves or enlist a qualified person to undertake checks before the loan closes to save time and money in the event of a construction contract litigation.

    Construction lending risks can be costly if not well managed. When a lender is well aware of the risks involved in construction lending, they can identify them on time and develop strategies to mitigate them before anything goes wrong. Here are common construction lending risks you should avoid.

    • Failure to complete a project within the construction interim period term

    When a budget is appropriately managed, the funds may run out before the project is completed, making it risky for the lender. To prevent such a scenario, ensure that the funds you release to the builders equal the percentage of completed work as verified by the construction progress inspection. That's why it's essential to maintain the balance sheet and draw inspections till the end of the project.

    Outsourcing independent review services to a company like Northwest Construction Control will assure lenders of efficient project monitoring as per best practices and help streamline draw inspection and offer you comprehensive risk mitigation solutions. Additionally, the lender should ensure that the construction loan is always in balance, the undisbursed funds stay sufficient to complete improvements, and draw disbursements are only released for completed work.

    • Low or no contingency budget

    If you don’t factor in a contingency budget in the overall construction cost estimation, any unexpected expenses will increase the budget, causing delays or preventing potential project completion. In addition, unintended repairs may arise due to health/safety issues, or other unforeseen factors may increase the budget, inconveniencing the project completion time. Adding a contingencies amount to the funding will help avoid such problems.

    • Lack of progress reporting

    Progress reporting allows you to monitor the project to ensure it's on schedule as per the loan term and the completion date indicated in the construction contract and loan agreement. In addition, progress reporting enables you to ensure coherency between construction workmanship and any draw application funds requests. You may hire progress inspection services to ascertain that draw application requests align with improvements made and verify other financial issues.

    • Failure to protect your first lien right

    Lien waivers ensure fair payments and are used to protect a lender’s lien position and helps avoid liens that complicate and delay projects. Since construction lending has various property lies, lenders should maintain a first lien to prevent losing control of funds disbursement. Different states have different lien forms, and ensuring you get the documents right will help you mitigate risks. As a best practice, ensure lien waivers are completed per state and local regulations, you complete the correct waiver form and submit on time, and that you only give payment for completed work and materials in place.

    • Missing or incomplete project budget and paperwork

    To reduce this risk, lenders should consider performing detailed project reviews themselves or enlist a qualified person to undertake checks before the loan closes to save time and money in the event of a construction contract litigation. When the budget or paperwork is incomplete or missing, unforeseen extra expenses increase the default risk. Ensure the review includes appraisal report, permits, and budget, and construction contract review.

    Endnote

    As a lender, you should know the lending risks you may face to avoid or create strategies to manage the risks thereof. Add these risks to your list of potential lending risks to ensure success and profitability. 

    Tags risk management | construction contract | construction loan

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