How to Manage Your Risk with Contractor Acceptance (7 Steps)
Updated on 9/5/2018
Consumer construction loans are quickly becoming the mortgage industry’s most sought after loan product. Every GSE and agency has a consumer-related construction to permanent loan product available and they are growing in popularity due to consumer demand, talent recruiting, and their attractiveness in the secondary mortgage market. So whether you’re considering new construction or renovation, lenders are excited about the new wave of construction lending.
These construction loan products are nothing new to the industry, but many of these programs are undergoing major overhauls to meet the growing urgency caused by the national housing shortage. There’s no doubt that the construction loan process has inherent risks and potential pitfalls, but much of this can be avoided by simply following industry best practices and developing programs that incorporate effective pre-closing risk management strategies.
MAKE SURE YOUR CONTRACTOR MEASURES UP BEFORE THEY BREAK GROUND
Construction lending takes on many different forms, but for purposes of this article, consumer construction loans are the focus–specifically, loans like the Fannie Mae or USDA Single-Close construction to permanent loans. These loans are made directly with the consumer (borrower) which give them the ability to choose a general contractor to build their home.
The borrower selecting their own contractor places a level of unknown risk onto the lender since the success of a project is dependent on the contractor completing the home on time and on budget. This risk can be mitigated with a review process known as contractor acceptance–not to be confused with contractor approval.
It’s a bad idea to rely only on word-of-mouth referrals or online reviews through this process. Finding a trustworthy contractor takes thorough research and a sound contractor acceptance review process. Here are seven simple steps to follow:
1. Gather Contractor Information
Every construction loan should have a contractor acceptance review performed. Providing well-documented information to the borrower and contractor during the application process allows all parties to know how the construction loan process works, what role the lender plays, and how/when the contractor is paid. This is a great time to provide the contractor with a contractor questionnaire so they can prepare the necessary documents and authorize the review process.
2. Check All Contractor References
During pre-closing due diligence, contractors should provide references to support their qualifications. These should include past customers, trade partners, suppliers, and banking references. The lender should then contact these sources and ask questions regarding the experience each reference had with the builder, the builder’s track record, a description of existing relationships (i.e. how many years they’ve worked together, bill payment history), as well as the contractor’s credit capacity.
Be on the lookout for these red flags when checking on references:
- Past customers either report negative experiences or don’t return calls at all
- Subcontractors state they have never done business with the contractor
- Cannot find history of completed new construction, or past customers report projects were renovations only (not full scale builds)
3. Verify Contractor’s License Is In Good Standing
A common sense next step is to verify the contractor’s license with the state contractors board or local entity that oversees licencing. Not all cities, states, or counties require a contractor to have a license, so due diligence is required by a lender to verify what the requirements are at the location of the build. Additionally, check that the contractor is properly licensed for a project in a specific location. 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.
4. Background Checks Are A Really Smart Move
Any lender is wise to make sure that the contractor is in good standing with the secretary of state and that the contractor– or their business entity– are not listed on the OFAC sanctions database.
It is also a good idea to run a background check on both the contractor and their business. Be on the lookout for liens, judgments, bankruptcies, and/or criminal activity. All of these issues could potentially cause problems in completing the project and are indicators of the contractor’s track record.
Credit also counts here. The contractor will need to fund their day-to-day operations during construction, so looking for positive credit is also extremely helpful. Checking the contractor’s tax returns or bank statements is another further idea to confirm the contractor has a viable business with positive cash flow.
5. Getting To Know The Contractor Is Critical
Even experienced construction lenders tend to overlook this critical step. After gathering all the information from the review process, schedule some time to speak with the contractor. I can’t stress how important this simple step may be and how much can be learnt in a 15 minute call.
It is also a great opportunity to discuss the details of a loan program and gain insight from the contractor’s perspective. Contractors will have questions about the construction loan process and how the draws, disbursements, and inspection processes work.
6. Gather Feedback And Track Performance
It’s a common misconception that the contractor acceptance process ends after the contractor has been accepted. After the contractor has been accepted, a lender should monitor the contractor’s performance by gathering feedback from borrowers and tracking progress of construction through the construction process.
A good construction loan program is built with good risk management that is efficient and can scale effortlessly. The Construction Loan Manager by Land Gorilla allows lenders to do this by helping them gather feedback with rating systems, activity monitoring, and contractor document tracking.
7. The Final Contractor Acceptance Review
The contractor acceptance process should bring potential red flags to the surface and allow the lender to make an overall decision to accept or reject the contractor that was chosen by the borrower. The final review process should also be performed by someone independent from the transaction (including compensation which should not be done by commission or pad with production bonuses).
Remember, it’s okay to say no to a suggested contractor. Being safe is generally worth while in the long run.
The Result Of A Quality Contractor Acceptance Review Process
A quality contractor acceptance review process is necessary for any lender originating consumer construction-to-permanent loans. The review process must also include a documented risk management policy. Staying inside a defined risk management structure helps ensure consistency and outlines a clear path to success.
The result of following these steps and mitigating risk from the beginning of a loan process will help stack the deck to have a successful program for everyone from the lenders, the borrower, and the contractor.