Construction loans: risks when the construction sector is in difficulty | Denton

The current state of the construction industry

The global construction industry is going through a period of considerable uncertainty, largely due to the COVID-19 pandemic and its by-products, and more recently the effects of the war in Ukraine.

Since 2020, global construction output has fallen 3.1% (compared to 3.0% growth in 2019).

Supply chains are in crisis, with builders and developers finding it increasingly difficult to source basic materials from domestic and international locations. This drives up the price of materials, as demand quickly outstrips supply.

This issue is compounded by labor shortages, self-isolation requirements, and lack of temporary migration limiting the ability of projects to proceed on schedule.

As a result, construction companies are finding it increasingly difficult to maintain positive cash flow, and a number of Australian construction companies have collapsed.

How does this affect lenders?

These challenges affect both the commercial and residential construction industry and can pose significant risks to the enforcement and collection of loans and security.

It is important that lenders are aware of the risks associated with construction loans and how to mitigate them, as the current pressures on the construction industry are expected to worsen.

How can lenders mitigate the risks associated with construction loans?

1. Pre-approvals

Lenders should verify projected construction costs to ensure that borrowers will be able to meet their contractual obligations, taking into account any additional increases in material and labor costs.

Documents can be collected from borrowers and other parties involved in the project to help lenders assess a project's viability/risks of non-completion.

Documents lenders may collect prior to approval include:

• a copy of any relevant permits, including plans and specifications approved by the competent authority;
• a copy of the construction contract, including all variations and the progress payment schedule;
• owners warranty insurance (if applicable);
• the manufacturer's "all risks" insurance policy and the exchange certificate for this policy; and
• a copy of the survey report completed by a licensed land surveyor.

2. Progressive withdrawals

Most lenders opt for a graduated drawdown structure to give them greater control in allocating funds and ensuring they are used for construction.

For greater certainty, lenders may require payments to be made directly to third parties such as builders, and loan agreements may require borrowers to provide a valid building insurance policy (with the lender listed as the interested party) before the final progress payment is made.

Lenders may wish to physically inspect job sites to confirm that work specified in outstanding claims has been completed.

A lack of drawdown by borrowers can be a red flag that a project has stalled. Lenders should proactively record and monitor the frequency of drawdowns to help identify projects facing challenges.

3. Comply with the terms of the loan agreement

Construction loan agreements generally confer a number of rights on the lenders, which can be exercised during the term of the loan, in order to mitigate the risks of the loan.

For example, if the loan agreement stipulates that construction must be started and/or completed within a certain timeframe, the lender should verify that these conditions are met and consider its options if this is not the case (which may include, for example, the right to refuse further advances, or to call default and call loan).

Compliance with these types of conditions (and other construction loan conditions) is also important as some lenders will set strict deadlines for construction loans to be eligible for funding.

It is important to be aware of the serious consequences that can arise if borrowers do not meet deadlines imposed by third parties to begin and complete construction, for example:

• by governments under the granting of a leasehold title - where the lease can be terminated, thereby voiding the lender's guarantee; Where
• by developers under land contracts - where "buy-out" provisions can be applied, obliging the borrower to transfer ownership back to the developer.

Generally, lenders have the right to inspect construction sites to ensure that construction is proceeding satisfactorily. While lenders have traditionally not committed resources to enforce this right, lenders may wish to carry out on-site inspections in certain cases - for example, where lenders have reason to believe that borrowers have breached their obligations. under the loan agreement.

4. Adjustment of evaluation measures

Now is the time to review and adjust property valuation metrics to ensure they account for rising material costs and labor shortages in the marketplace.

Next steps

Lenders should take proactive steps to manage their construction loan portfolios during these uncertain times. Given the current climate, it has never been more vital to ensure that construction projects are funded appropriately and executed on time.

Therefore, now is the time for lenders to review their portfolios to flag any accounts of concern and consider possible solutions, and also to determine whether it is appropriate to modify their credit policies for new construction facilities. .

When lenders are going to act on construction loans it is important that proper notice is given to customers and in some cases notice may in fact be mandated by the loan agreement.