Pub. 8 2020 Issue 3

www.uba.org 12 NEW STANDARDS FOR RISK AND BEST PRACTICE IN CONSTRUCTION LENDING By Mike Lacey, CoFi R ewards for running a tight con- struction 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 success- ful construction portfolio so your Finan- cial 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 signifi- cantly reduces the risk of foreclosure. FRAUD According to a study done by Grant Thorn- ton, each year the construction industry los- es 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 communi- ty. A good friend of mine recently got a construction loan and hired a contrac- tor 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 nev- er 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 cate- gory 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 con- struction 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 pay- ments burdensome. Frequently we see lenders make payments to the general contractor with the expectation that they will pay the subcontractors and suppli- ers. 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 fur- ther protects lenders from project failure. BEST PRACTICE Building a construction lending best prac- tice 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 improv- ing 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 compar- ing individual line items to other projects. Further protect yourself by having a conversation with the contractor and the