While construction lending can be profitable, it also comes with inherent risks. For example, in the last five years over 10% of banks reported failure of construction projects, and over 50% of those failures occurred as a result of construction cost overruns. Additional failures occurred because of project delays, contractor or subcontractor failures, and dwindling investment capital. 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 have a risk management policy.
Lenders can optimize their construction loan programs and mitigate their risk at the same time with a risk management policy.
What is a risk management policy?
What does a risk management policy include?
Purpose of a risk management policy
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
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
Purpose of 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.
Construction Lending Risks
There are a few risks that are prevalent in every construction loan program.
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.
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. 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. This is a significant risk since 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. 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.
4. Failing to Protect Your First Lien Right
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.
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.
Take the next step
Construction loan program risk management policies are important for the success and health of the lending institution. For more information on construction loan risks, download this whitepaper, “10 Construction Loan Risks and How to Protect Your Investment.”