Rewards for running a tight construction loan portfolio are huge and can lead to massive growth. Failure in construction lending can be catastrophic and has led to the collapse of many financial institutions. Being prepared for a recession, while poised for growth can be difficult. Here is what you need to know to run a successful construction portfolio so your Financial Institution (FI) reaps the rewards and skips the failure.

Risk

Foreclosure

Although this is a worst case scenario, construction loan write offs are real and painful. I recently had an interaction with a community bank that had to write off a $1 million residential loan. The legal fees and lost interest cost them approximately $150,000 plus the black eye on their loan loss provision. There are signs a project is heading toward foreclosure. Projects fail for reasons such as, performance disputes, fraud, overfunding, mechanics liens, and others. Recognizing and taking action early on each of these items significantly reduces the risk of foreclosure.

Fraud

According to a study done by Grant Thornton, each year the construction industry loses approximately $1 trillion dollars to fraud. In the US. half of all losses are through payment fraud. Astronomical numbers that are only increasing!

Fraud is rampant here in our community. A good friend of mine recently got a construction loan and hired a contractor to build their dream home. During construction the contractor had my friend sign a draw request. After it was signed the contractor added a line for $60,000 under “contractor fee”. The FI paid the request and the contractor never returned to the project. This happens all too frequently. Protecting yourself from payment request fraud requires significant effort, clear systems, and the ability to see projects as they really are in real time.

Overfunding

According to a study done by KPMG, 69% of projects go over budget by more than 10%. Typically stakeholders are made aware of overruns at the end of the job, when it is too late to make adjustments. This puts the project in a higher risk category where finding the additional funds is difficult. We have seen FI’s end up eating costs just to get the loan off the books. Management of funds at all stages of construction is critical to avoid overfunding. With proper systems and controls a lender can take action early in a project to avoid massive failure at the end.

Funding trades that are never paid

Current lien laws make processing payments burdensome. Frequently we see lenders make payments to the general contractor with the expectation that they will pay the subcontractors and suppliers. But what if they don’t? Even if the lender has paid the general contractor and received the lien waiver, projects will still be stalled if subcontractors and suppliers are not paid. Putting in the extra effort to collect lien releases from all parties further protects lenders from project failure.

Best Practice

Building a construction lending best practice for your institution doesn’t have to be difficult and will pay huge dividends. Your clients want to be successful, and you have the power to help them with a streamlined and secure system. Here are a few areas to think about when improving your best practices:

Cost Review

Projects vary in scope, size, complexity, and design. Frequently we see lenders use a cost per sf method to determine feasibility. If you dive in deeper, you can find out more about a project by comparing individual line items to other projects. Further protect yourself by having a conversation with the contractor and the borrower separately to see if there are gaps in expectations and pricing. Accessing databases of construction costs will give you financial insight into understanding the project before it begins.

Contractor Review

Not all contractors are the same. Appearance is not always what it seems. Most commonly we see lenders verify finances and reputation to determine contractor strength. This is good, but often doesn’t tell the whole story. Something that will be truly telling is contacting subcontractors that do and don’t work for the contractor. Generally, subs know every contractor and can give you additional insight into their reputation. Another resource is your local general contractor associations like the HBA and AGC. They typically have great information about contractors who are or aren’t members.

Lien waivers

We have yet to find a FI that manages this aspect of construction to perfection, and frankly this puts a ton of construction lending at risk. The next downturn will expose the lenders that didn’t take liens seriously. It is not easy. It also can be a point of friction between you and your contractor. If you can be thorough while also making this part of your contractors job easy, you have hit the jackpot.

Payment

Recently the state of Florida was defrauded by a scammer that was able to send their wiring instructions to the government via email. Tens of millions of dollars were sent to the scammer rather than the contractor. Payments via check have their own problems. Matching checks to invoices is problematic and are frequently mismatched. This leads to heavy call volume, improper lien filings, and reconciliation between all stakeholders. Fortunately the solution for payments is fairly simple. Detailed communication accompanied with each check and validated business addresses will solve most of the problems with checks. When wiring or sending ACH payments, getting the information from a reliable source, double checking with a call, written document, or trusted software protects you from payment fraud.

Rewards: Peace of Mind and Growth

With a simple yet capable system for construction lending you can rest easy that your FI is prepared for any downturn, and has the ability to scale your construction pipeline. We have seen that lenders who take the time to create proper systems actually take less time to process payments, and issue new loans. We have also seen that creating these systems also helps their clients be better at their jobs and keeps them coming back to the FI. Best systems = decreased risk, increased efficiency, and organic growth.