Recent Developments in Construction Lending Risk Mitigation: Expose the Myths to Reduce the Risks

CRE Finance World, Autumn 2012

Recent Developments in Construction Lending Risk Mitigation: Expose the Myths to Reduce the Risks Executive Director — Technical ServicesDamian Wach, AIA Hypothekenbank Frankfurt How the recent financial downturn exposed certain construction myths, and what lenders can do to dispel these myths and reduce their construction loan risk. C averaged about 18% per year, more than three times the material estimates and other conditions. The owner may even beis awarded (often termed an “allowance”), most GMP contractsmay leave the owner responsible for the difference between initialestimates and final subcontract value. Similarly, a GMP contractmay insulate the contractor from inaccuracies in allowances,onstruction lending has taken a beating in the mindsof lenders during the market downturn — largely due tomyths that are amplified as default rates creep higher.Since 2009, the construction loan delinquency rate has delinquency rate of conventional commercial mortgages during this responsible for gaps in contract scope of work. It all depends on same period.1 the GMP contract details. Lenders often unwittingly accept GMP contracts that effectively make their borrower (not the contractor) When staring down a project going south, many lenders have been the primary budget guarantor in these situations. troubled by the unpleasant realization that it is difficult to identify potential issues before they reach the critical crisis stage. In addition, Options: A construction lender’s pre-closing due diligence should once that stage hits, there are limited corrective options. hinge around a competent review of the GMP contract. With the assistance of a capable construction consultant and, in some Adding to the rude awakening, certain myths about commercial cases a construction attorney, the lender needs to be comfortable construction lending are contributing to these lender difficulties that the cost responsibilities and cost management provisions of when problems arise. This article will identify and deconstruct the GMP contract are consistent with loan underwriting and will a number of construction myths and propose adjustments to not expose their borrower or sponsor to unacceptable levels of construction loan underwriting and loan documentation standards budget risk. to strengthen lenders’ hands in addressing risk. Also, an incomplete or poorly coordinated set of construction Commonly Held Construction Myths documents within the GMP contract will leave a project exposed to increased budget risk. If possible, construction lenders should Myth #1: A Guaranteed Maximum Price (GMP) Contract obligates seek to delay closing their loans until there is a complete or nearly the constructing entity to guarantee a maximum price. complete set of project documents. Reality: A GMP contract is essentially an open book, cost-based As an alternative to a GMP contract (AIA form A102), a stipulated contract with a separate management fee. This type of contract sum or lump sum contract (AIA form A101) is structured to assign has gained popularity in recent years primarily because it works the direct cost risk to the contractor. Although this type of contract well for fast-track projects wherein the construction documents would generally result in a higher final cost than a GMP, it relieves are not yet completed when the construction contract is signed. the owner of significant cost risk. Developers will often prefer an Also, many owners believe the open-book format of a GMP open-book GMP contract, whereas lenders may perhaps be better contract provides cost transparency and thus, better cost control — served by a stipulated sum delivery method. characteristics that appeal to owners. In practice, however, GMP contract performance often falls far short of owner’s expectations Myth #2: The role of a Construction Manager (CM) provides more and construction lender’s needs. This is because the typical GMP comprehensive and objective management of a construction project contract usually includes numerous conditions under which this than that of a traditional General Contractor. “guaranteed” maximum cost can be exceeded – and often with the additional cost borne by the owner. An experienced contractor can Reality: The term “construction manager” is used so broadly it is craft an agreement that shifts significant portions of the cost risk almost impossible to define. Traditionally, a construction manager to the owner. was an owner’s representative who advised the owner on construction issues and communicated the owner’s intentions to the general From a lender’s perspective, a GMP contract can be favorable contractor. However, the construction manager’s role has gradually or unfavorable depending on the contract terms. The devil is expanded over the years while the general contractor’s role has truly in the details. For example, although the contractor may be decreased. Today it is common for owners to engage work with a responsible for estimating the cost of a task before a subcontract construction manager who assumes all field responsibilities, thus CRE Finance World Autumn 2012 40


CRE Finance World, Autumn 2012
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