Table of Contents
- What is Contactor Acceptance
- Why ‘Approving’ Contractors is Not Recommended
- Risk Management Policy
- Contractor Referrals: In-house Vs. Consumer Direct
- Contractor Acceptance Process
- Red Flags
The volume of residential construction loans increased by 2.4% in the third quarter of 2017. Construction loan management and authorization is changing, which means construction loans are growing to be an even more rewarding space for lenders. When entering (or reentering) construction lending, there are many different aspects to consider.
Contractor acceptance is a key component to construction lending, but unfortunately it is often overlooked or neglected. Lenders must understand the concept and process of contractor acceptance to successfully build and maintain an acceptance process. This includes understanding the benefits of these programs, the different types of referrals requested, important red-flags that may be encountered, the importance of a risk management policy, as well as an important tool that can help streamline a contractor acceptance workflow.
What is Contractor Acceptance?
In the simplest terms, contractor acceptance is the process of a lender vetting a contractor, including their background and references, in order to mitigate any possible risk they may pose. This is a matter of pre-closing due diligence because a lender will work with this contractor for the life of the construction loan which means they could be a business partner for anywhere between four to nine months. This acceptance process is a vital part of the loan approval process because if the lender does not accept the contractor, it will slow down loan closing time and potentially increase risk.
Throughout this procedure, a lender conducts a background check on the contractor, and reviews their references–both previous clientele and financial references like banks or subcontractors.
However, contractor acceptance is more than just determining if an individual contractor is a good business fit–It also includes developing a sound contractor acceptance policy within an institution.
Why ‘Approving’ Contractors is Not Recommended
Lenders use precise language in contracts, and for good reason. Precise use of jargon as well as a definite knowledge of these terms ensures the lender’s investment is secured and the loan is given the best chance for success.
The difference between contractor approved and contractor accepted is critical and mainly comes down to mitigating any problems down the road.
If a lender signs documents stating a contractor for a certain build is approved they are open to potentially being dragged into any disagreements or altercations between the borrower and contractor through the life of the loan. The use of approval in documents shifts liability from the contractor, to the party who approved them to work on the project (in this scenario, that would be the lender). This difference is key because most construction loans involve a contractor brought to the lender by the borrower, and ultimately if the borrower has any problems during the construction phase, the lender who approved the contractor could be held liable and/or find themselves in an awkward and potentially vulnerable situation.
However, if a lender accepts a contractor, this suggests they are merely allowing the contractor to be a third party in the loan but are not holding themselves to any responsibility if anything with the contractor were to go wrong.
Accepts also implies the lender has done their due diligence in determining if the project should be entered into contract with regard to standard construction lending protocol and any extant contractor acceptance policies. The simple practice of choosing to use accepted instead of approved guards against unnecessary exposure to risk.
Risk Management Policy
Defining a contractor acceptance process including potential exceptions to that process are two important steps to creating a construction lending program that mitigates risk before the loan documents are even signed. However, there’s no one-size-fits-all solution. In general, it is a good idea to approach any policy (existing or under construction) from the perspective of each party involved.
The first priority will always be to address the wants and needs of the lender or institution, followed by the priorities of the contractor. Some specifics to consider during this process include the following suggestions:
- How many months will an accepted contractor remain accepted before they need to submit another application? Will the lending institution allow for self-builds (construction done by the borrower) or family builds (construction done by someone related to the borrower)?
- Is there a graded or tiered system to organize contractors based on experience and builds per year? If so, how will different levels of contractors be categorized?
Of course, exceptions may need to be negotiated from time to time, but addressing each exception as it arises can be confusing, time consuming, and lead to inconsistent outcomes.
Instead, consider common exceptions faced previously during the creation of the risk management policy. A good place to start is to detail who in the organization has the authority to make the final decision when these moments arise.
Regardless of the size of the institution, a well-defined risk management policy that is easy to implement will ensure user adoption and accuracy across the organization.
Contractor Referrals: In-House Vs. Consumer Direct
The most common types of contractor referrals are in-house and consumer direct. In-house referrals are contractors who have done business with the lender before and are therefore referred to the project by the lender. These lenders likely have a history with the lender–maybe even a few closed deals. These contractors are great referral partners once trust is established and expectations are set. There is a high probability of repeat business and increased growth, and increased number of projects for both the contractor and the institution once these relationships are set.
However, even if a contractor has been previously vetted and has a proven track record, they must still conform to any new contractor acceptance policies as they are created. This includes keeping updated licenses, insurance documents, and possibly financial documents on record.
Contractors with consumer direct referrals are suggested to the lender directly by the borrower–as the name suggests. In this scenario, the client has vetted the contractor. While this partnership may turn out beneficial for everyone involved, the fact that the borrower has done the first round of vetting means consumer direct referred contractors are the perfect scenario to utilize a contractor acceptance policy so each party involved in the loan is protected from the start.
Contractor Acceptance Process
Each lender or institution can create a contractor acceptance policy uniquely suited to their needs and goals. However, there are a few basic best practices that can help any process get started.
- Gather contractor information: Lenders should consider a standardized contractor questionnaire to maintain consistency and uniformity
- Check every one of the contractor’s references: See the below “red flags” section for more specifics
- Verify the contractor’s license is in good standing: Contact the issuing agency of the contractor’s general liability insurance policy to verify that it is still active in the amounts shown on the declaration page
- Complete comprehensive background checks: include checks on the contractor, his business, references, and financials
- Get to know the contractor: A quick 15 minute phone call with the contractor will be very enlightening and also gives the contractor an opportunity to ask questions to the lender
- Safe and secure: This is a good time to introduce technology to streamline the contractor acceptance process where it is safe, compliant, and accessible by all parties
A great contractor acceptance policy helps lenders mitigate risk by identifying red flags.
While collecting references from a contractor, it is important for a lender to contact their most recent customers. This context can help a lender piece together when their most recent build occurred and general customer satisfaction with the contractor.
Generally, a lender would prefer to see a build completed within the previous 12 months, as anything longer than that (especially multiple years earlier) is a common red flag and warrants further investigation. However, reasonable explanations exist for gaps in working history, such as a leave of absence due to illness, or a period of work done for another company.
Other concerning things to hear from customer referrals include bad references or unhappy experiences especially with regard to a contractor going over budget or time-frame as well as references who never call back.
Supplier or subcontractor references can pose similar red flags to customer references, but also have their own potential pitfalls. A lender should be weary if a reference listed does not recognize or states they have never worked with the contractor. Lenders should also pay attention to what suppliers or subcontractors say about their line of credit, timeliness of bill payment, and if they have a generally good or bad relationship with the contractor. It is also a good idea to question the reference on specific projects they’ve worked on with the contractor in question. Checking all these can give a lender a good overview of the contractor’s reputation and if they are a good business match.
Lastly, lenders need to be familiar with all the information collected throughout the reference process when interviewing the contractor themselves. Keeping track of continuity between different interviews is key. Take note of any discrepancies, and look into them after the interview. This may extend the contractor vetting process, but this small detour could potentially save a loan from costly missteps.
In the end, red flags like this are not deal breakers, but their presence should certainly cause lenders to proceed with caution through the remaining contractor acceptance process
A contractor acceptance policy is a smart move for any lender whether they have a robust construction lending program or haven’t yet begun. Contractor acceptance provides risk mitigation, protects against projects going too long or missing their budget, keeps every interested party thoroughly organized and informed, and builds lasting partnerships for continued revenue.
We are happy to offer a free tool that will help you begin your contractor acceptance process. It includes collecting contractor information, how to request necessary documents, authorizing the contractor acceptance review process, review multiple contractors, and check tasks needed to complete each review.