Construction Lending Risk Management
- Apr 25, 2017
Construction lending has been the Achilles’ heel of the real estate industry for a while now, so it’s only natural to explore solutions that could ease the process. Risk management policies and strategies can help all parties involved. Smaller businesses can also benefit from this approach, as it basically all comes down to discipline, flawless planning and budgeting, and construction progress monitoring. Bill Tryon, director of strategic development at Partner Engineering and Science, discussed the trends in construction lending risk management and how smaller companies can benefit from such programs.
What are the main trends in construction-lending risk management?
Tryon: The rapid expansion of construction loan portfolios and lack of adequate controls were significant drivers of bank failures during the recent recession. The main trend today is caution—major lenders are evaluating construction risk management policies limiting their exposure in overheated markets, and syndicating loans to spread risks.
In today’s competitive environment, construction risk management is playing a more prominent role across the industry as a whole. Lenders recognize that projects should be watched closely because the industry’s current shortage of qualified labor may dramatically compound construction risks. In hot markets, developers and lenders alike should consider whether contractors are overcommitting, driving projects to increasingly engage C-tier subcontractors. Project costs are rising across board and spiking in hot markets. Competition puts subcontractors at high risk of being poached, which means paying more to get and keep quality labor. The impact of default or delays is magnified, so risk management strategies like funds control, budget reviews and progress monitoring will help prevent default and/or loss of labor.
How do High Volatility Commercial Real Estate (HVCRE) rules influence construction lending now?
Tryon: By requiring developers to contribute more equity or lenders to reserve more funds against potential losses, HVCRE has depressed the overall volume of construction lending regulated lenders. To some extent this has resulted in decreased ability to compete with non-regulated lenders.
There is still resistance to some elements of HVCRE and the criteria for identifying HVCRE loans can still be confusing. Some lenders are reportedly over-allocating loans as HVCRE in an effort to play it safe, while others may be interpreting the terms loosely so as to include fewer loans in the HVCRE classification. At a recent conference of the American Bankers Association, regulatory staff from OCC, FDIC and the Federal Reserve board discussed revisions to the rules that may be proposed this summer, which could include a simpler definition of what constitutes HVCRE.
How does HVCRE impact small businesses in real estate?
Tryon: One of the difficulties of the HVCRE provisions is its application to both speculative real estate development and small business expansion. Revisions to the rules to distinguish between how the rules are applied to these distinct categories would likely benefit small businesses. In other cases, construction loans to small businesses may be exempt from HVCRE. These loans need to be considered individually to minimize obstacles to small business lending.
Tell us more about risk management technologies and software platforms in the field.
Tryon: Developers are increasingly adding a variety of smart technologies, such as drones for survey and data collection, as well as BIM, GPS and sensor capabilities to traditional tools to make the design and development process more efficient. However, lenders are much more interested in new technology platforms and software that can help projects run smoothly. Web-based platforms such as EDR’s Collateral 360 and others can provide lenders with an automated workflow and simplified administration process that improves not only the management of lending risks, but also provides greater transparency and compliance when auditors come in.
Could you give us an example of a useful tech tool?
Tryon: Lenders are willing to pay for tools such as our SiteLynx platform to consistently understand project risks during construction. Sophisticated project management platforms like this give lenders the information for any and all properties at their fingertips at any point in the project. Being able to see how the work is progressing, how resources are being allocated and how the budget is being managed is essential to keeping potential risk factors under control.
How can smaller real estate investors implement risk management?
Tryon: Many small investors and developers lack a consistent risk management plan. They sometimes rely on contractors or architects to help them through projects, but this can quickly result in decreased profits and even failed developments. It’s important for investors to independently evaluate the risks associated with property ownership and development. In the early stages, consultation with owner’s reps and other market professionals can help drive decisions towards specific investment goals.
Construction risk monitoring can be too costly for a smaller developer. Are there any alternatives or solutions? How can this issue be approached?
Tryon: In most cases, the reverse is actually true. The failure to monitor construction and understand and control risks is significantly more costly than informed oversight. Smaller developers really can’t afford to expose themselves to the losses that can come from not monitoring the construction process.
What can you tell us about construction lending for small real estate companies? How can these businesses finance their projects?
Tryon: Finding financing can be difficult for small real estate companies. Existing banking relationships can sometimes be critical, but a compelling case for your project can help developers find the right lender. Clearly defined budgets, plans, schedules, sales, risk management plans, etc. instill confidence in lenders, which can make all the difference.
Image courtesy of Partner Engineering and Science