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Keys To Successful Construction Lending

Lerch, Early & Brewer's Legal Update

With construction booming throughout the Metropolitan Washington, DC region, it is important that both borrowers  and lenders pay attention to details in the construction loan processes. A successful construction loan, where the  project is completed in a timely fashion and the loan is repaid as agreed, is achieved by careful coordination  between the borrower and the lender. The costs associated with a construction loan will almost certainly reflect the attention to the process by borrower and lender; the less the attention to the detail by the parties, the greater the cost to both.

The process is much like any other real estate loan transaction, with the added requirements that the borrower and lender ensure that the building is properly designed and constructed, and all parties involved in the construction are paid. Fundamental to the success of the project is a borrower who is familiar with the construction process and who assumes responsibility for its oversight.

Beginning with the first meeting between borrower and lender, the borrower should deliver all available documentation to the lender (see below.) Throughout the process, the borrower and lender must communicate frequently in order to ensure that the lender has the most up-to-date versions of all documents. A successful construction loan typically proceeds as follows:

  • The borrower submits a formal loan application together with copies of all available underwriting documents including the purchase contract, organizational documents, construction contract, preliminary plans and specifications and back title information. The borrower should coordinate the delivery of these documents, as the lender who becomes overly involved in supervising the parties risks lender liability exposure if problems develop later or the project is ultimately unsuccessful.
  • The lender evaluates the project and issues a “term sheet” outlining the circumstances under which the lender would commit to making a loan for the project, with the borrower advancing the lender’s anticipated costs associated with the appraisal and environmental review and legal costs. Not all lenders utilize a term sheet; however, those that do are less likely to chase the deal that never closes.
  • The borrower elects to proceed by the terms outlined in the term sheet, and the lender receives and reviews the appraisal and environmental reports for the project. The lender will likely engage a technical consultant to evaluate whether the building is properly designed and can be constructed within the borrower’s construction budget. This person must be working with the same construction documents that the borrower’s representatives are working with.
  • The lender issues a formal commitment letter, which can be either very specific, or can contain only fundamental deal terms while leaving negotiation of specific points for later. Whatever the form of the document, the borrower and lender should have reached an agreement as to what will be required to collateralize the loan and what information the borrower will be required to provide during the construction process, such as an ALTA survey, contracts with the general contractor and key subcontractors, additional surveys, builder’s risk insurance coverage, etc.
  • The borrower provides additional underwriting materials, including complete copies of the real estate purchase contract, all organizational documents, final drafts of the construction contract and the contract with the architect, up-to-date copies of the final plans and specifications, a preliminary construction budget, insurance policies, a proper survey of the property, evidence that the property is properly zoned and all real estate title documentation. The contract with the general contractor should never be finalized until after it has been reviewed and approved by the lender.
  • No construction should proceed until after (i) all required permits have been issued; (ii) the loan closes; and (iii) the deed of trust or the mortgage is recorded in the land records. Contractors and material suppliers have lien rights in construction projects – and these rights may be superior to a lender’s rights as mortgagee if the proper procedures are adhered to.
  • The lender should work closely with counsel to ensure that the construction loan agreement is tailored to the transaction, removing requirements that the lender has no intention of enforcing. At this stage, the parties should reach agreement as to how the loan proceeds will be advanced and how the loan will be repaid. Do the parties contemplate that there will be partial releases of the project as it is completed – as in the instance of a condominium or housing project? Will a permanent lender provide funds to repay the construction loan, and, if so, what underwriting requirements must be satisfied before that can take place?
  • Closing takes place. The lender partially funds the loan to provide acquisition funds. Almost without exception, the borrower should expect that the borrower’s equity will be injected into the project before the lender makes an initial loan advance.
  • Construction proceeds. Loan advances are made periodically as the borrower provides evidence of compliance with the lender’s construction loan requirements, and both borrower and lender should make provision to have the construction inspected as it proceeds. Remember, the lender’s inspector does not work for the borrower; a lender who allows a borrower to rely upon the lender’s inspector is potentially exposed to lender liability claims for any construction defects. To the extent required, disbursements are made through a title company and “pending disbursement” endorsements are provided.
  • The building is completed. At the time of completion, the borrower should expect to provide documentation showing that the project is complete and compliant with all regulatory requirements such that a certificate of occupancy has been issued, all contractors and suppliers working on the project have been paid and lien rights extinguished and that all other conditions of the construction loan agreement have been satisfied.

If all proceeds as planned, the project will be completed at or close to budget. The wise lender and the wiser borrower will proceed with the construction process assuming that they will encounter problems. If borrower and lender work together, the result will be a soundly constructed building and the loan will be repaid.

Arnold D. Spevack is a principal in the firm’s Commercial Lending and Real Estate Transactions groups. He can be reached at (301) 657-0749, or via e-mail at adspevack@lerchearly.com.

This content is for your information only and is not intended to constitute legal advice. Please consult your attorney before acting on any information contained here.

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