Three Critical Checks You Need Before Accepting Any Contractor

Every construction and renovation loan lender has the same goal: originate construction loans in a safe and cost-effective manner. In order to achieve this goal and maintain the best interest of the lender as well as the client, lenders should be willing to have open conversations about contractor acceptance.

A healthy process for contractor acceptance allows the lender to be risk-averse without leaving money and opportunity on the table.

Contractor acceptance can feel overwhelming and insurmountable, especially for those who are new or don’t have a process in place yet, but there are a few simple checks to make contractor acceptance a lot less daunting and a lot more thorough.

Generally,  any lender or financial institution must take inventory of their current processes and policies regarding contractor vetting. This includes asking: What does the current risk management policy look like?  How does this process become defined for each individual lender? What does this look like for a builder?

Each institution will answer those questions differently, but it often comes down to the size of the institution.

For example, community banks and credit unions may rely on a board of directors or group of department heads at every level of the loan’s life. This group may help to curate a contractor acceptance strategy as well as review individual loan applications along with other more detailed day-to-day work regarding loans.

However, a larger depository may have the resources to develop a Construction Division Department and are motivated to find policies and procedures that help govern contractor acceptance at the national level.

When building policies around contractor acceptance, it is important to consider how exceptions will work within the process. Not every case is cut and dry, and certain points may raise a need for an exception.

But regardless of the size of the institution, it’s very important to create a policy and procedure for contractor acceptance that is well defined and easy to follow so each member of the team can find repeatable success and avoid common pitfalls.

To safeguard against contractor acceptance feeling too overwhelming, we have provided three critical checks to make your acceptance process even easier and safer.

The three critical checks of the contractor acceptance process:

1. Reference Check

Business and private references are a vital first step to contractor acceptance. Ask the builder directly for a list of references including past clients and subcontractors they have worked with. Contact former customers and ask about the contractor regarding original timelines, if the contractor finished within that time, if the project was on budget, if they enjoyed working with the builder, what the outcome was when something didn’t go as anticipated, what type of project the contractor completed, and if the customer would recommend the contractor to a friend.Additionally checking supplier and subcontractor references is hugely helpful to find out if the builder was making payments on time, if they ever had past-due payments, and what the resolution was. Discover their credit line and liquidity to ensure they are financially responsible.All these questions help to determine if the contractor has the experience and the available credit to support their day-to-day operations.

2. Background Check

Running a background check on the builder’s company is a logical next step in the process, but running a check on the builder individually is also a smart move, especially if their business is a self-proprietorship. Check for liens, bankruptcies, different names for the business, any incorporations or associations. Are there any potential conflicts of interests? A private background check on the builder is also important to look for any potentially problematic behavior. Finding a criminal record and any personal suits can ensure against a borrower or their family feeling uncomfortable with a builder working in their home.

3. Financial Check

Ask the builder for tax returns, profit and loss statements, and balance sheets.With tax returns, it’s important to look for clues and possible red flags while also allowing the contractor to explain everything in the tax return. Lenders typically receive two years of tax returns and will highlight any positive income and any losses or reductions of income from year to year. Common reasons for income variance may include purchasing new equipment, obtaining a new building for operations, or perhaps they lost clientele, or owe their suppliers. It’s the lender’s responsibility to cross reference the documentation and other references that have been supplied by the contractor.Profit and loss statements will show the contractor’s sales. Check to see if it matches what they have already provided in the terms of the number of houses sold, the average price point, and the cost of goods sold. It is important to see if the numbers add up logically on this P&L statement. It makes sense for the cost of goods to increase as the revenue goes up. The opposite isn’t going to make sense and might be a possible red flag. An extra measure is comparing the profit and loss statements with the tax returns to see if they align.

With balance sheets, it’s important to look for liquidity. The contractor needs to have the ability to support their day-to-day operations and fund their business between draws. Check balance sheets for signs that their lines of credit are at their maximum capacity with no available funds to pull from.  Also, make sure the builder or contractor answered on their questionnaire what funds they need when starting a new project to ensure this number is in line with their liquidity and past balance sheets.

These three things are important elements of due diligence to help lenders determine the risk level of a builder, and mitigate any potential financial risk they may pose before accepting them.

Contractor Tracking Best Practices

Keeping track of a contractor’s performance can be paramount to maintaining a successful business relationship with the contractor and ensuring customer satisfaction. Say for example a lender has two deals with ABC Builders. Both are supposed to be finished in six months but took almost 10 months in the end. Either the contractor or the borrowers are paying interest during construction, which means in this situation, they have to pay an additional four months worth of interest, and the lender is losing money while they wait for the project to finish. This could potentially be a large sum and would definitely leave a bad taste in the mouth of most parties involved.

For this situation, tracking is important to see if ABC Builders makes a habit of going over their timelines or budgets. Knowing this tendency, a lender can take this into consideration when ABC Builders is recommended for future projects.

If project performance is tracked, lenders can much more readily discuss and reassess contractors for future work. Tracking also helps lenders determine their own best practices, such as setting limitations on how many loans one particular contractor can take on at a time, or deciding a good time to authorize a full scale build to a contractor who typically specializes in renovation.  

Lenders have the ability to mitigate and determine risk policies for their builders.

Whether with construction loan management software, a spreadsheet, or some other option, it’s an important and recommended best practice to keep track of contractors and their progress on a project, as well as client relationships as you go.

For more information on contractor acceptance, and to get started on your own contractor acceptance process, watch this on-demand webinar now.

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