PERSON OF THE WEEK: One corner of the commercial real estate world that has suffered particular stress is construction lending. This week, MortgageOrb.com caught up with Penny Roach, executive vice president and director of sales and administration for Granite Loan Management, to see how construction lenders are dealing with the fallout and working to avoid past mistakes.
Q: Risky construction lending has been closely associated with several FDIC bank failures. How far has the industry come since the boom years in terms of project review?Â
Penny Roach: Unfortunately, not as far as it should. Even though more and more banks are embracing the concept and putting risk mitigation procedures in place, most lenders do not possess the expertise in-house to adequately manage the complexities associated with construction lending.Â
We have had the opportunity to review thousands of distressed construction assets, and there is one consistent theme: most distressed construction projects were undercapitalized from the onset, and when the market crashed, the issues were compounded by declining values. Many of these projects should never have been approved in the first place; however, the lender didn't review the project from a feasibility perspective prior to closing the loan.
A project review is vital to ensuring a bank is lending sufficient funds to complete the asset, but to be successful, it requires far more expertise, which is where many financial institutions fall short. It isn't just as simple as reviewing a budget for deficiencies. All project components must be reviewed and analyzed, including the construction contract, budget, plans and specifications, engineering and soils reports, permits and prepaids. A detailed review of the project documentation will highlight any pre-construction issues, such as budget deficiencies and front loading, construction schedule issues, contractual conflicts between the lender's policy and the construction contract, and under-detailed plans and specifications, which often foreshadow change orders and cost overruns.
One of the most complex elements of project review is the examination of pre-closing statutory requirements. Statutory compliance is a complex body of law that can vary drastically from state to state and needs to be actively managed to avoid issues during construction. In addition, the lender needs to inspect the project location prior to the loan closing to ensure construction hasn't commenced and to identify any other pre-close project concerns that may need to be addressed. It's important to identify a local, independent, qualified inspector who acts as the eyes and the ears of the project during pre- and post-construction. Lastly, it's imperative to ensure the contractor and/or developer is qualified to build the project from start to finish and deliver the project on-time and within budget.
Q: After the loan has been approved, what additional risk mitigation steps can lenders take?
Roach: Overall, lenders need to look at their risk mitigation plan in terms of prevention, early detection and loss mitigation. Having a feasible project and a qualified contractor is important to the overall success of construction. Those two pre-close components lay the foundation for a successful construction project. Obviously, a comprehensive project review falls into prevention, but also so does a contractor review. Not all lenders feel comfortable reviewing their contractors, for fear they may damage their contractor-friendly program, but knowing a contractor's experience level, financial stability, and if they are licensed or carry the appropriate insurance certainly highlights any issues before construction begins.Â
Regarding risk mitigation steps post-close, certainly a lender needs to have an underwriting process in place to oversee the disbursement of funds. Monitoring change orders, cost overruns and inactivity is crucial, in addition to statutory compliance with regard to mechanics' lien laws to ensure subcontractors and suppliers are paid in accordance with the state statutes.
One of the most important components of a prudent funds disbursement system is not only ensuring that an on-site inspection is performed prior to the release of funds, but also that the borrower and contractor both authorize the draw. Managing construction progress in conjunction with the maturity of the project, in addition to the project activity, will ultimately benefit the lender when reviewing their loan-level and overall portfolio risk. Daily, weekly and monthly risk management reports should be available in order to detect problems early on, prior to the project becoming a workout type situation. The importance of proactively managing construction projects should never be underestimated.
Q: What's being done to resolve problem construction loans? How has the industry matured in terms of loan workouts?Â
Roach: It seems across the board that most lenders are doing everything they can to deal with the massive glut of problem construction loans that exists within the industry. Lenders are working to focus on special assets and creating divisions to deal specifically with workouts – construction or otherwise. Investors are looking to purchase distressed construction projects at steep discounts, and equity investors are trying to capitalize on construction assets in the hopes that the market improves and they realize significant financial gains. However, the question is, what are their strategies for success?Â
Granite, who was selected as one of the government's primary construction lending management contractor's, started in the business in 1992 as a Disaster Recovery Management group, so we are intimately familiar with what it takes to resolve such complex projects. Overall, there seems to be an awakening to the concept of forensic inspections and distressed-property analysis, which is one of the more crucial steps when trying to right a problem project – knowing what you have in front of you before trying to move forward.
A lender must first understand the gravity of the problem and its best course of action. The best course of action is determined by analyzing the project details, identifying solutions and ultimately developing a budget (cost) to rectify the problem. Many times, there are multiple solutions with varying costs. The goal of the lender/investor is to identify the best course of action in parallel with the most cost-effective solution. Construction lending is a highly complex product that requires a tremendous amount of expertise to right a wrong. A lender/investor should rely on both internal and external resources when making a prudent construction risk management decision.
Regarding how the industry has matured in terms of loan workouts, I think it's pretty obvious that you can't attend an industry seminar without hearing a segment on special assets or workouts. This is imperative to ensure that lenders and investors alike not only learn how to cope with these types of loans, but how to prevent them from occurring in the future.Â
Q: What is your forecast for the future of construction lending?
Roach: Lenders will continue to treat construction lending with the respect it deserves. It is not for the weak-hearted. Those lenders that had established prudent risk management policies continued to capture market share as many lenders exited the construction market in 2008. I don't believe construction lending will ever return to its peak, but as the excess inventory is absorbed, construction will return – and trust me, those lenders that were conservative through the economic downturn will be ready to capture greater market share. Until then, lenders will proceed with caution and may re-enter the construction market as they see improvements in property values and a shift in the economy.
Additionally, regulators will play a more integral role in scrutinizing a bank's construction portfolio and the corresponding capital requirements. Whereas capturing greater market share was the focus for so long, it has now come down to mitigating risk or striking a balance between sales and credit. A lender can never truly eliminate construction risk, but they can mitigate risk by developing safeguards that will serve them well in both good and bad markets.
