Reducing Financial Risks for the Lender on Projects

Construction loan monitoring identifies problems early in the process before they become costly headaches.

Financing construction projects can be a risky business. Major threats to schedules and budgets are common, and they can be costly for developers.

These in turn pose risks for construction lenders. Add problems stemming from the COVID-19 pandemic, supply chain interruptions and staff shortages, and it is more important than ever to do rigorous financial, legal and construction-related commercial due diligence to ensure that lenders know about all risks relating to a project so they can properly underwrite it. 

Once the decision is made to finance a project, the focus for lenders then shifts to the construction phase, which includes the lender’s third-party construction consultant monitoring the project’s progress. One of the key purposes of construction loan monitoring (CLM) is to identify potential problems at an early stage so they can be resolved before they become major issues. CLM helps mitigate the risks inherent in construction lending such as poor contract language, insufficient contingencies, poor cost estimates, unrealistic schedules, and insufficient insurance and bonding by the contractor.

CLM also monitors construction phase risks such as quality issues, schedule issues, overfunding for incomplete work and timing of funding, to name a few. The CLM consultant will also review the timely payment of general contractors and subcontractors to avoid contractual disputes and liens being placed on the property for unpaid work. 

In the past, the role of the CLM consultant has been performed by quantity surveyors, project managers and project controllers, who are typically deemed third-party independent consultants with much less at stake than developers, general contractors and subcontractors. However, the role has developed into its own unique set of services. It’s not just about selecting a quantity surveyor or project manager; it’s about choosing a CLM specialist who understands and can explain the construction-related risks to a lender on a project. Identifying risks to lenders and raising red flags early is critical. This can only be achieved by a strong monitoring role, which includes physical site visits, correspondence analysis such as schedule and budget reviews, and payment application reviews. It is important to have the experience to understand what raises a red flag on a construction site. 

A skilled CLM consultant starts with a strict set of due-diligence tasks while the loan agreement is being drafted. A CLM consultant will require certain markers to be met before the loan agreement is executed. All these requirements are presented to the lender team in the form of a detailed due-diligence report. This usually happens just before the preconstruction process. Within the due-diligence report, the CLM consultant uses their expertise to analyze and comment on items that include but are not limited to:  a developer’s project team, consultants, general contractor and major subcontractors; budget and estimates (including contingencies and allowances) from the developer and general contractor; the form of the construction contract; insurances applied on the project; proposed construction schedule; development permit status; and any subcontractor work that has already been procured. All this information then translates into a project risk section in which the CLM consultant will identify risks associated with schedule, budget, the construction team, environmental considerations, permits and any other general risks that may pose a threat to the project. 

Once the lender team is satisfied that all due-diligence checks have been made and the loan agreement executed, the role of the CLM runs through the preconstruction phase (design and procurement) to the construction phase and close-out. It typically ends when the loan is paid back in full. During preconstruction, constructability checks are made once each of the design stages has been achieved. Budgets and estimates are reviewed, and any major scope increases and overruns can be identified to the lender through the issuance of an updated due-diligence report. In many cases, the loan agreement is executed midway or near the end of the design phase, so most of the preconstruction analysis gets identified during the due-diligence reporting stage of the loan agreement drafting. Each project is different, however.

Construction-phase CLM is equally as important for lenders, because as the project moves through the cycles of trade-specific payouts, budgets and schedules are tested against actual progress. The construction-phase CLM role is identified by two integrated activities:

CLM inspection. This involves a review of the monthly payment application to verify that all costs are in line with the draw requirements and that the work is progressing. It also ensures that they are in line with draw requests, change order reviews and requests that have been met. Technology now plays a bigger role than ever during the CLM inspections; this includes drones and handheld software on iPads. 

CLM reporting. This involves the submission of a monthly report after the CLM inspection for a particular month has been completed. The report includes, but is not limited to, cost checks, schedule reviews, risk analysis for any critical issues, contingency reviews, change order review, and developer and contractor documents. 

In summary, it’s imperative that lenders find CLM partners with the appropriate expertise, such as having knowledge of national architectural and engineering firms and contractors. Sector experience is also critical. For example, an airport has different requirements, specifications and project risks than an office or residential tower. 

A CLM partner must have a proven track record of seeing projects through until loan closing. A national footprint is another advantage because it can centralize the CLM work. This eliminates the need to interview new partners in new locations for every project.

Aled Jenkins is a principal in the Los Angeles office of Rider Levett Bucknall.