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Lending & Credit Risk Construction Lending CRE Lending Credit Risk Management

Managing real estate and construction lending risk

Abrigo
February 7, 2023
Read Time: 0 min

How construction administration units mitigate construction lending risk

Construction lending involves unique risks and requires specialized processes. Could your institution benefit from forming a real estate and construction administration unit?

You might also like this webinar, "How to manage a high-performing construction loan portfolio."

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Takeaway 1

The OCC recommends that construction lending risk be managed by specialized real estate and construction lenders who report to the credit department. 

Takeaway 2

Construction lending risk is unique. The relationship between the customer, contractor, and lender requires inspection, draw, budget and lien management.

Takeaway 3

Banks and credit unions must have staff with the knowledge and experience to identify, measure, monitor, and control construction lending risk.

Construction-specific teams

Effective construction lending risk staff units

Construction lending risk is a critical consideration for banks and credit unions because the collateral on construction loans is not fully realized until the project is completed. That means financial institutions need effective systems for:

  • Construction progress and disbursements of loan proceeds
  • Ensuring project workers and suppliers are paid
  • Monitoring property performance and repayment
  • Ensuring that property taxes and property insurance premiums are paid

To ensure those systems function well, many banks establish a real estate and construction administration unit—sometimes called a RECAD unit—responsible for managing construction lending.

In its 2022 Commercial Real Estate Lending update, the OCC advised that staff members who manage real estate and construction lending risk should report to the credit department of a bank rather than to the real estate department. The scope of a construction administration unit’s responsibilities might include the following:

  • Budgets
  • Contingencies
  • Guarantees
  • Bonding
  • Letters of credit
  • Plan and cost reviews
  • Inspections and draws
  • Lien requests
  • Interest reserves
  • Contractor reviews and approval

Dev Strischek highlighted three of these responsibilities in a recent webinar on construction credit administration and lending risk management:

  • draws and inspections
  • budget management
  • lien management

Unique lending system

Overseeing draw requests and inspections

Draw requests and inspections are a key feature of construction lending and the primary way construction loans differ from other loan types. In construction lending, the builder initiates periodic draw requests, which are requests for project completion payments. Both the builder and the borrower must sign draw requests. Payment requests must include details such as a breakdown of what project components are being paid, a copy of the payee’s invoice, a W-9 form, and any conditional lien waivers.

Once a draw request is made, construction lenders dispatch an independent inspector to the site to review and evaluate project completion for each component. All payments are subject to the inspector’s confirmation of project completion progress, and loan advances are made based on the project completion percentage as allocated in the project breakdown.

For example, if 50% of a project’s doors are installed, the lender must only advance 50% of the funds allocated for doors. The lender should not release retention funds until the project is 100% complete, meaning that the notice of completion has been recorded and a certificate of occupancy has been received.

Technology can help reduce or eliminate common problems that construction lenders face during the complicated draw process. For example, construction loan management software can automate much of the tracking required for preparing draw requests for approval and can ensure approvals and relevant documents are easily accessible for auditability.

Banks looking to save time and free up staff so they can spend more time on analyzing projects and understanding the portfolio rather than manual tasks should seek out collaborative, easily accessible, customizable software for streamlined construction loan management. Technology increases draw interest income by speeding up the entire process of approving and funding draw requests.

Changing plans

Managing budget changes to mitigate construction lending risk

Banks send inspectors to construction job sites to evaluate the project’s progress so that the bank can release funds for the next steps and properly manage the budget. But no matter how precisely a budget was planned before construction began, sometimes it is necessary to make changes.

Perhaps a borrower decided against their original plan to purchase new appliances and wants to change the budget, reallocating those funds to another construction area. A construction credit administration unit is responsible for approving that change.

Budget changes arise from many factors, such as specifications errors, components' availability, and edits to an original design. Approval of these changes depends on the cost of the change, and changes must be evaluated in terms of the projected budget, borrower’s equity, and loan commitment. Changes with higher prices require credit approval and more equity, so appraisers must determine the change’s impact on the project’s total value to minimize construction lending risk.

Lenders need to have effective systems for tracking and managing construction project budget changes in order to mitigate the risk of overfunding.

Learn 10 ways construction loan management software can save you valuable time.

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Lien laws

Understanding and avoiding liens

Lien laws protect suppliers and contractors from nonpayment of costs incurred in building improvements on someone’s land. In most states, a supplier of materials to a construction project has the right to file what’s called a materialman’s lien. The lien attaches to the property and threatens the forced sale of the property if payment is not secured. A typical materialman’s lien protects suppliers of labor and materials, though there are variations from state to state.

Due to their nature and the potential impact on the loan, lien requests also need to be managed effectively.

Liens and other documents filed and sent throughout the lien process are the responsibility of a construction administration unit. Preventing the project’s contractors and suppliers from using the lien as a legal tool means the financial institution needs to ensure that the material and labor costs are consistently and quickly paid off. Most states allow 90 days for payment before a lien can be filed, but lenders must be familiar with their state laws to ensure projects are compliant.

The best way for construction lenders to avoid liens being placed on loans in their portfolio is to require a conditional waiver on every draw. Because conditional waivers only go into effect when the transaction occurs, the payer and payee are protected. The vendor receiving payment maintains the right to file a lien until the check is cashed, while the lender is protected from double payment (paying the party hired for the project and also being faced with a lien placed on the project).

Construction lenders should also require unconditional waivers for every vendor’s final invoice as well as for all payments to the general contractor. Unconditional lien waivers are provided by contractors or suppliers after they’ve been paid. These forms immediately release or waive the right to file a lien, as payment has already been made.

OCC advice

Other OCC considerations

If your financial institution is evaluating its policies to better manage construction lending risk, a good first step is to compare CRE and construction lending tasks and functions with those listed in the updated OCC handbook. Problems occur when banks fail to establish prudent CRE lending objectives that are compatible with their risk appetites or strategic plans.

Imprudent CRE lending can result in significant loan losses and has been a cause of failure in banks with significant CRE exposure. Banks must have staff with the knowledge and experience to identify, measure, monitor, and control construction lending risk.

The OCC advises that financial institutions:

  • Restrict construction lending to skilled and experienced lenders in real estate finance.
  • Require appropriate analysis, underwriting, and approval of borrowers and contractors.
  • Ensure that construction lending is monitored and managed by real estate and construction administration staff.

Manage risk & avoid defaults. Read the whitepaper, "Red flags and warning signs of contractor failure."

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About the Author

Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo’s platform centralizes the institution’s data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth. Make Big Things Happen.

Full Bio

About Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

Make Big Things Happen.