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CRE Finance World, Autumn 2012

Recent Developments in Construction Lending Risk Mitigation: Expose the Myths to Reduce the Risks “Over the past 15 years, construction consulting, like many other due diligence features, has seen its scope of work trimmed by cost-conscious lenders and assertive borrowers.” •Require monthly submission of subcontractor estoppels, pay Another mean of mitigating budget risk, is applying a healthy receipts or enhanced lien waivers that disclose all cost disputes contingency within the budget. While a discussion of the different and potential future change orders. types and uses of contingency is beyond the scope of this article, a simple guideline is this: the greater the budget uncertainly, •Require monthly anticipated cost reports that are approved by the greater the contingency should be. For a lender, some early both the contractor and owner. Surprisingly, most construction warning signs of budget uncertainty are: budgets based on very loan agreements do not require these reports with every requisition. incomplete drawings; budgets that include significant allowances They are a critical tool to evaluating a loan balance. (place holders for unresolved costs); and budgets lacking executed subcontracts. The amount of contingency needed for a project Myth #4: Actual construction bids from experienced contractors should be determined through collaboration between all parties provide a fairly accurate indication of actual costs. involved in the budget — including the lender and their consultant. Reality: Most contractor estimates are produced within a competitive Myth #5: The lender’s construction consultant can adequately bidding environment, and as such, a bid price is usually derived access construction risk by attending a monthly requisition meeting. more by stratagem than by objective estimating, known by anyone who has ever bid on anything. Add to this the inherently fluid nature Reality: Over the past 15 years, construction consulting, like many of construction costs, and it is easy to see that construction bids other due diligence features, has seen its scope of work trimmed often do not represent actual costs. by cost-conscious lenders and assertive borrowers. Consultants typically visit construction job sites for only a monthly meeting and The pressure to stay below a cost threshold may compel an owner walk-through, where they evaluate the work, assess problems, or contractor to accept unrealistically low bids, rather then face gaps and review the monthly contractor requisition. This means the between design and cost. This type of pressure is sometimes termed consultant is observing the project for only approximately four to “build-to-budget,” and refers to the tendency to shape subcontracts six hours each month, which is probably inadequate for a complex to fit the budget, often by making unrealistic assumptions or or relatively large project. In addition to the failure to grasp project allowances. For example, if all concrete bids come in higher than details, limiting project exposure to a single monthly meeting anticipated, a contractor may remove minor contract elements allows a deceptive owner or contractor to control the consultant’s under the assumption that they can be completed by another observations and paint a sanitized version of project reality. If the trade, or may assume very favorable union labor rates or material consultant or lender gets the feeling that their walk-through is purchases, or even assume fewer weather delays. The result is being choreographed to keep them happy, it probably is. a concrete subcontract that meets the budget but contains so many unrealistic assumptions that future change orders are Options: During loan term negotiations, the construction lender virtually assured. must make sure the loan agreement grants them — and their consultant – unfettered access to the construction site and the Options: Most lenders engage a consultant to perform a relatively construction participants. The lender should also work with their modest budget review that compares the subject budget to historical consultant to craft a scope of consulting work proportionate to construction costs. This may be adequate to get a general sense of the project size and complexity. At minimum, for a project of even budget health, but is not robust enough to challenge a contractor’s moderate complexity the lender should consider having their opinion or detect gaps in contract scope. On large commercial projects, consultant attend the regular progress meetings between owner, lenders should consider engaging a professional construction architect and contractor, which typically occur weekly or bi-weekly. estimator to produce an enhanced construction budget review. Acting only as an observer in these meetings, the consultant will Such a review provides an independent estimate of materials and hear the project concerns, problems and disputes being discussed. labor costs, as well as a review of each subcontract scope, on a This information is essential to a proper risk evaluation, and frees level comparable to that of the contractor itself. the lender from relying solely on the good graces of their borrower or contractor to disclose information impartially. CRE Finance World Autumn 2012 42


CRE Finance World, Autumn 2012
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