A Foundation For Lending To The Construction Industry

Mark Briden, Director
MorrisAnderson

As the real estate market continues to revive from the 2008 downturn, construction contractors are becoming busy again. Defaults on commercial real estate loans have now hit an all-time low of less than 1%, according to the Federal Reserve report for Q1 2016, down from 8.75% in 2010. So, what’s to come and where’s the risk of lending into the construction industry? As lenders look to expand their footprint, the construction industry appears to be a great opportunity, but at what cost?

As the real estate market went through turmoil over the past eight years, it’s difficult to predict where the market will be in the next five years. However, it’s important to know the intricacies of construction loans and surety bonds. For purposes of this discussion, I’ve assumed these construction projects are bonded.

When construction contractors face difficult times, what happens to their project(s) and more importantly, how does the secured lender preserve their collateral and minimize losses? The majority of defaults stem from three distinctive groups, 1) financial issues, 2) operational issues and 3) overexpansion. The initial step is for the company to identify the problem by discussing the problems with the bonding agency, secured lender and often times, a financial advisor familiar with the construction industry. By notifying the bonding agency, the company may further be able to avoid all the difficulties that come with having to deal with a claim, as well as having to repay the surety for its coverage of the claim (losses from a defaulted project). It is always a better option to notify the surety as soon as possible if the company is experiencing trouble with the execution of the project.

Depending on the situation, sureties have a number of possible approaches to a potential or already-occurred contractor default. There are four primary approaches to such situations, though a surety will usually try to avoid contractor default if notified on time. The surety has four options:

Take Over – Surety will step in, take the project over and assume control, typically when the project is near completion.
Tender – Surety will hire a new contractor to complete the project.
Contractor Assistance – Surety will assist in the completion of the project and often fund financial losses.
Obligee Completion – Surety will allow the contract owner to finish the project on their own, without a contractor. Typically, this will only be allowed if it does not expose the surety to further risk.

Losses can be mitigated through negotiations with the surety, but often times the company chooses not to communicate any difficulties with their surety, as they may not be able to obtain bonding for future jobs. This is an important element, because the secured lender will be aware of such hardships much sooner and will need to address the potential defaults in a cautious manner.

What does this mean to the secured lender? The secured lenders typically have a second position behind the surety, as the surety bares the risk of completing the project; therefore secured lenders have been compelled to make critical decisions as to the best course of action to protect their collateral and ensure repayment. As opposed to immediately declaring a default under the loan documents, many lenders have opted to negotiate loan workouts with their borrowers which, if properly structured, can salvage the project and maintain the viability of the construction loan. No lender wants to hold an unfinished project as collateral, as they will have far more limited options of repayment. When a secured lender deems the loan to be in default, there is an elevated risk of having the contractor ceasing construction, filing liens, vandalism, and the loss of a permanent loan commitment. Additionally, due to the current frothy credit market environment, the contractor may find alternative lending sources and offer to pay the secured lender a severe discount.

When the company is facing a loan default, the lender must choose which route to follow: 1) pursue its remedies for the default or 2) restructured debt.

Pursuing Remedies Under the Loan Documents

The secured lender allows the contractor to continue construction and finalize the project. The company and secured lender will need to work with a financial advisor to determine the time and economic relief the borrower requires to complete and carry the project. Once the magnitude of such losses have been identified, it’s imperative to seek additional collateral and modifications to the loan agreements. However, often times this is where the company seeks alternative lending and offers a severely discounted buy-out of the loan.

If the secured lender agrees to complete the project(s), the financial advisor’s focus should be monitoring the progress of construction and reviewing contractor requisitions. Any proposed revisions to the construction contract, budget or schedule necessitated by the workout must be reviewed by the financial advisor in conjunction with the company’s architect and contractor.

Restructured Debt Service

The lender may also need to consider economic relief, such as a reduction in the interest rate or deferral of the interest payments. In some cases, forgiveness of principal or interest may need to be considered in light of the overall objective to maximize the lender’s realization on the loan. As indicated above, seeking additional collateral is imperative, but also requiring additional capital will help mitigate losses and carry the project through completion. In such instances, as part of the loan workout, the lender will need to consider providing the borrower with more flexibility to obtain mezzanine loan financing or joint venture equity financing, which may involve admitting a new controlling (or jointly controlling) developer, or granting considerable rights to a new mezzanine lender or equity provider.

Additional Compensation or Security

The loan workout should also serve as the lender’s opportunity to ensure that it is adequately compensated and fully secured. In being asked to extend the term of the loan, reduce its originally expected return on its investment and/or increase its risk of the borrower’s non-payment, the lender may seek to offset such risk with increased compensation and/or security.

A successful construction loan workout will address the problems facing the borrower in completing the project on time and within budget. In accommodating the borrower in this manner, the lender should ensure that it is adequately secured and possesses enhanced enforcement mechanisms, should there be a further loan default.

The nuances of the construction industry are very important to understand, prior to jumping in to what seems to be a low-risk environment. With commercial real estate loan defaults at an all-time low, I expect aggressive lenders to dabble in this industry without fully understanding their position as secured lenders. More importantly, when the default rate begins to climb, these aggressive lenders may face difficulties in a workout situation.