Blog > A Lender’s Guide to Construction Loan Risk Management

A Lender’s Guide to Construction Loan Risk Management

Lenders can optimize their construction loan programs and mitigate their risk at the same time with a risk management policy.

 

The demand for new housing has skyrocketed. As of June 2021, the U.S. housing market needs 5.5 million more units, according to a report by the National Association of Realtors. This incredible need is growing and the opportunity is there for lenders to provide construction loans. However, there are no two ways about it: construction lending can be risky. For a loan to be successful, lenders must maximize the possibility for every project to meet the following three objectives:

  • The construction goes ahead as planned and budgeted 
  • The project is completed on schedule and paid back on time 
  • The lender makes money on the loan

 One of the goals of construction lending is the conversion of the construction loan into an amortizing permanent loan that is either sold into the Secondary Mortgage Market (Single Close Construction to Perm), securitized, or placed into the lender’s loan portfolio as an investment. To reach this goal and mitigate the risks inherent in construction lending, you must understand the common risks and have a policy to mitigate these risks at scale.

Table of Contents
What is a risk management policy?
What does a risk management policy include?
Purpose of a risk management policy
Most common construction lending risks
How to write a risk management policy
Risk concentration policy

What is a Risk Management Policy?

A risk management policy for construction lending is a policy for the express purpose of mitigating the risk involved in originating construction loans. The goal and purpose of a risk management policy is to get construction projects to completion without failure. Comprehensive risk policies take into consideration the risks involved from pre-close to post-close.

What Does A Risk Management Policy Include?

Every lending institution will have to make specific decisions around their own risk management policy, but in general plans and policies around the following points should be covered:

Follow state and federal regulations: Understanding and exceeding state and federal regulations is the smartest thing any lender can do for their construction loan program

Builder/Contractor acceptance: Reference, background, and financial checks on contractors and builders play a vital role in a risk management policy. Learn more about contractor acceptance >

Loan administration procedures: Either in-house or using a third party, make sure everyone involved is able to safely and efficiently manage all loans

Clear and precise construction draw process: Look at the entire construction draw process and make sure every aspect of the process is considered; starting with the contractor experience and ending at fund disbursement

Progress monitoring: Determine a frequency for which to check the progress of the construction and how it compares to the projected time frame and budget

Inspections by a qualified third party: As part of your progress monitoring, inspection reports must deliver specific and clear information

Exception handling: Every good risk management policy has a procedure in place for when exceptions need to be negotiated. Identify the most common exceptions and build them into your policy.

The Purpose Of A Risk Management Policy For Construction Loans

A risk management policy is important because it sets up the parameters that lead to successful construction lending now and in the future. A risk management policy for construction lending is to identify, analyze, and define the risks that are inherent in residential construction lending and to establish a risk policy that will be adopted by the lending institution.

Common Construction Lending Risks

There are common risks that are prevalent in every construction loan program. These risks should be a non-issue when you have a comprehensive risk management policy in place. Review below to make sure your policy will stand up to these common risks:

1. Non-completion of the house or project within the term of the interim construction period

If the budget is improperly managed, funds can run out before the end of the project. This scenario is risky for every party, but particularly so for the lender. One of the most important ways of preventing this is to ensure that your construction loan holdback is calculated and managed correctly; builders should never receive more funds than is supported by the percentage of work that they have completed, as verified by the construction progress inspection.

This magnifies the importance of draw inspections for maintaining balance sheets all the way to the end of the project. The lender’s job is to ensure:

    1.  The construction loan remains in balance at all times
    2. The undisbursed funds remain adequate to complete the improvements
    3. Draw disbursements are released only for work completed

2. Low-to-no contingency budget

Without a contingency budget, an unexpected expense, such as a price increase in materials, will push the project over budget, potentially preventing or delaying completion. In the current market of increasing material costs, a borrower’s contingency reserve that is financed directly into the loan can be a good idea. The borrower will need to qualify for the increase in cost to build and the home may need to appraise higher, but the benefit could provide a cushion to lessen the financial burden of increasing construction costs.

Additionally, unplanned repairs may arise that are needed due to health or safety issues. Both the FHA 203(k) and Fannie Mae HomeStyle renovation loans require 10-15% of the actual repair amount to be held for contingencies. Many factors can result in going over budget and it is not always possible to avoid them. However, the solution is simple: never close a loan unless the project budget specifies funds are available for contingencies.

3. Cost-plus contracts increase risk of default

In a project controlled by a cost-plus contract, the borrower pays the contractor for the project expenses plus an allowance for profit. These contracts are legal, but they can be bad business for a lender. The final cost of the project is undetermined until it is done—there’s no check on spending during construction. The contractors and borrowers may be comfortable with this kind of arrangement, but you, as the lender, shouldn’t be. Lenders need to know how much the project is going to cost, how the funds will be controlled, and whether the work is progressing according to the agreed upon project schedule. This level of insight is impossible with a cost-plus contract because there is no control over spending. Consequently, lenders may reach the point where they don’t have enough funds to cover the project.

4. No progress reporting

Timelines and budgets get out of hand without progress reporting. Reporting ensures that construction is proceeding on schedule relative to the term of the loan and the completion date referenced in the construction contract and the construction loan agreement. While some chose to only request progress reports at the time of a draw request, we suggest monthly progress inspections should be required regardless of whether or not a draw application has been made to ensure timely completion.

Progress reporting also allows you to ensure that construction workmanship and progress is in balance with any funds requested by a draw application. Using trained professional inspectors that produce detailed inspection reports to verify that draw application requests are supported by the improvements made and in place are key to this portion of reporting and managing the risk on the loan. This also allows for a check and balance between what is being built and the original approved building plans.

5. Missing or incomplete project budget or paperwork

The lender can reduce this risk by performing a detailed project review themselves, or by enlisting a qualified vendor to perform a review before the loan closes. These kinds of pre-checks will save time and money in the long run as it saves you from costly litigation over the construction contract. A balanced project budget is essential to give a complete overview of expected spending. When the project budget is incorrect, the unforeseen extra costs increase the risk of default. A project could also be significantly delayed before it even starts if other essential paperwork is missing or incomplete. At a minimum, this review should include an appraisal report, a budget review, permits, and a construction contract review.

6. Project not completed in accordance with appraisal report

The proposed construction appraisal shows the future value of the property, and the final completion report assesses if that has been achieved. But by the time you’ve received the final report, the damage may have already been done. Let’s say the plan lays out a 2,500 sq. foot house but the completed property ends up being 2,200 sq. feet—this is a major problem. Now the value of the property is likely to be worth less than the original estimated value on which the loan is based. This could potentially jeopardize the lender’s collateral. Have the property regularly inspected to ensure that the progress of the project is meeting the standards set out in the appraisal report. This is necessary to ensure the lender is able to obtain a final inspection and recertification of value, a final title endorsement, and a certificate of occupancy. Without these, the loan would most likely be non-salable on the secondary mortgage market because the home would be worth less than the loan amount.

7. Lack of insurance leaves you unprotected

No amount of paperwork, planning, or budgeting can protect you from every eventuality, which is why key insurance policies are in place prior to construction starting.

In particular, decide what types of insurance are necessary to make sure the build is secured in case of any worst-case scenarios:

Private Mortgage Insurance (PMI): Protects you in the event that the buyer falls through (You cannot require a borrower to take out PMI if they have paid a down payment ≥ 20%)

Builders Risk Insurance: Protects the property during construction from fire, wind damage, theft, vandalism, and other disasters

Builder’s General Liability: Protects the property from damage as well as physical and reputation-based injuries (Also protects the contractor from being held liable for any work completed by subcontractors)

8. Failing to Protect Your First Lien Right

Lien waivers are an essential part of ensuring fair payment. They are used as a tool to protect a lender’s lien position and avoid liens that complicate and delay projects. Construction lending brings with it various liens on the property at different times. Lenders need to make sure that they maintain first lien position. Lost lien priority puts you in danger of losing your control of disbursement which is absolutely a worst-case scenario.

The one thing that is most often overlooked and puts lenders the most at risk is using the wrong lien form. Because lien forms vary by state it can be easy to accidentally pull the wrong form. Additionally, you could be bumped out of first lien position if even one data point in the form is filled out incorrectly. Getting lien documents right is key to mitigating risk.

As part of best practice, you must ensure the following:

    • Waivers are completed according to local and state regulations
    • Waivers must be completed on the correct form and submitted on time
    • Payment is only given for work completed or materials in place

9. Disbursing Funds Without Title Updates

Another important way a lender can protect their lien position is by ordering a title update at each draw, ensuring that no mechanic’s or subordinate liens will overtake the priority of the mortgage or deed of trust. Ordering title updates can be cumbersome with several manual steps in the process, taking anywhere from 3-5 days before the report is received. This has caused many lenders to take on additional risk by avoiding the process altogether. Recent technology advancements have enabled a digital title update process, providing a much faster and seamless operation, shortening the turn-around time to 24 hours in many cases.

Title Updates Should Include:

    • Current deed information (i.e. grantor, grantee, recording dates)
    • Property tax status, when available
    • Lien and judgment information (i.e. creditor, amounts, and recording dates)
    • Copy of the most recently recorded deed

10. No Assignment of Rights

If the borrower walks away from the project and you need to take over, it is essential to have rights to the construction plans, construction contract, and permits. Also consider anything else that is necessary to complete construction of the current project. Alternatively, without an assignment of rights in place, an architect or contractor does not have to abide by their original contract and may quit the project or ask for additional funds to continue.

11. Builder/Contractor Steering and Vetting

On residential construction and renovation loans, steering the borrower to a specific builder or contractor exposes the lender to a high amount of unnecessary risk. Borrowers must do their own research and interviews of potential contractor or builder candidates, ultimately selecting the one for their project and taking ownership of the decision. Lenders should never steer borrowers toward a specific builder or contractor.

The general contractor plays an essential role in the construction process, as they are responsible for completing the project on time, on spec, and on budget. They have a high level of influence over the project. In the event of poor vetting or lack of due diligence from the lenders prior to the close of the loan, the general contractor could jeopardize the entire project.

You can reduce your risk by ensuring they meet the following criteria:

    • State or locally-licensed
    • Experienced in the specific type of construction required for the project
    • Positive trade, supplier, and customer references
    • Acceptable financial information that proves they run a financially-viable business
    • Personal and company background checks passed

How To Write A Risk Management Policy

Risk management policies will differ from lender to lender, but in our experience, we have seen a similar outline as a common thread. View the risk management policy template below to get started on your outline:

Risk Management Policy Template Outline

  • Define your purpose
  • Define the unique risks your institution faces within:
    • Physical risks
    • Financial risks
    • Legal risks
  • Detail concentration risk policy
  • Detail best practices
  • Define objection handling

Risk Concentration Policy

It is incredibly important to avoid stacking or layering risk components into the loan transaction whenever possible. Risk layering may pose an unacceptable level of risk to your lending institution. For this reason, you need to include a risk concentration policy into your overall risk management policy. We recommend placing risk concentration limits on builders, mortgage insurance carriers, appraisers, and geographic areas.

Construction loan program risk management is important for the success and health of the lending institution. Download the 11 Construction Loan Risks and How to Protect Your Investment in a convenient PDF.

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