Every lending institution wants to protect their investments. This can be tricky given the fact that construction to permanent loans have a greater tendency to be high risk. Institutions set boundaries to make sure their portfolio contains the right product mix and also weighs the various levels of risk associated with different loan types. Ideally, each product portfolio has its own risk management policy to help keep everything on track and in-line with the wider goals of the institution. Are lenders missing something when it comes to their risk management policy?
Even seasoned construction lenders are not immune to these risks. Lenders who have originated construction loans for years can still miss things that could potentially be disastrous. To help you cover your bases, we have compiled three risks for lenders to look out for: one is obvious, one is less so, and the last is a hidden risk.
The Obvious Risk: The Borrower’s Contractor
The success of the project usually comes down to the general contractor as this is someone a lender relies on to coordinate the actual construction. For this reason, it is imperative that lending institutions implement some type of contractor acceptance process. Knowing the warning signs of a high-risk contractor is the first step in protecting your investment.
Flag a contractor and look for further information or context if their background check shows: no builds completed in the last 12 months, no history of completing the type of project proposed, multiple and frequent businesses or name changes, unsatisfied customers, subcontractors unwilling to give a positive review, or a low credit score. While some of these red flags may be completely innocent, you will not know this until you investigate further.
Keep in mind though, a general contractor can put a construction to permanent loan at risk in ways not associated with these red flags. Any project would be severely derailed by a contractor up and leaving. While some risks cannot be entirely mitigated, vigilance and research are your best bet to keeping your loans safe.
The Less Obvious Risk: Missing Or Incomplete Budget Or Other Paperwork
First, an incomplete project budget is a definite risk to the health of a loan. The general contractor needs to have an accurate estimate of their material and labor costs before ground is ever broken. So, the budget should be as close as possible to the reality of the project. Surprises do often arise, so contingency funds between 5-15% of the total budget should be factored in from the beginning. For the sake of the project, don’t allow anything to move forward without checking and double-checking the entire proposed budget.
Secondly, important paperwork missing from the loan documents could seriously threaten the loan. With a multitude of critical papers required for each construction loan, there are hundreds of opportunities for error that can leave you open to risk. Missing documents are definitely against best practice, but even incorrect dates or fields left blank can leave you open to risk if any aspects of the loan are disputed in the future. Ensure documents—including appraisal reports, budget review, permits, and construction contract review—are correctly and completely filled out in the document package.
This drudgery of double checking documents can be irritating and time-consuming, but in the end, it’s worth the effort. These extra steps keep lenders out of the grasp of risk as well as the financial headaches and legal fuss that accompany these types of mistakes.
The Hidden Risk: Not In Primary Lien Position
The last risk is one lenders may have identified as a problem, but may not anticipate it as a risk: lien position. It’s the most hidden risk of the ones we’re focused on here because even though there are so many variables seemingly out of the lender’s control, most lenders believe they’re doing their due diligence with regard to maintaining primary lien position. But unfortunately, it’s easier than you’d think to use the wrong lien form (for instance, one for Nevada when the construction is happening in Utah) or fill it out just incorrectly enough to bump you, as the lender, out of first lien position. Something as simple as an incorrect date can take away your position. This may not sound like a fatal flaw because loans close without issues all the time that actually have issues with lien priority.
The difficult problem is that you generally don’t know you have an issue with lien priority until it’s too late. Lost lien priority puts you in danger of losing your control of disbursement which is absolutely a worst case scenario. Luckily, this risk is one of the easier ones to mitigate, as all it requires is a manual inspection of lien documents before they are filed (checking dates and use of the correct document for the location of the construction), or using a document management service that checks these for you automatically. A small investment like either of these can prevent these mistakes from ever happening in the first place.