Navigating Construction Loans, Part 2
- Oct 17, 2018
The first article in this series highlighted how lenders structure construction loans in order to mitigate the inherent risks of timely, on-budget completion of construction and lease-up. This article describes various guarantees typically required by construction lenders, as well as approaches that borrowers can deploy to protect themselves.
Most construction lenders (especially banks) require the borrower and/or its principals to personally guaranty full or partial repayment of the loan. The guaranty must be provided by a creditworthy individual or entity with demonstrated financial wherewithal to repay all or a portion of the loan. In the event of an uncured default, the lender has full recourse to the guarantors’ assets. In some cases, the guaranty may be partially or fully released based on achievement of performance hurdles such as lien-free completion or stabilized occupancy.
During the Great Recession, many guarantors were sued and lost everything in Chapter 7 liquidation. Consequently, developers are generally reluctant to provide personal guaranties. Fortunately, it is possible to obtain construction financing with little or no personal recourse; however, other guaranties such as completion and carry are still required. Typically, non-recourse construction lenders offer considerably lower leverage than recourse lenders, at higher pricing. A recourse lender might fund as much as 70 percent of project costs, whereas the non-recourse lender might only lend 50 percent. This means the borrower wishing to avoid recourse has to contribute more equity than a recourse deal.
Virtually every construction loan has a completion guarantee. This is a guarantee of lien-free completion of the project, including soft costs other than financing charges. The project budget will include both hard and soft cost contingency reserves, which are the first line of defense in the event of cost overruns. In some cases, the developer will also obtain a Guaranteed Maximum Price (GMP) contract from a creditworthy general contractor as a means of further mitigating risk. The GMP shifts the risk of hard cost overruns to the contractor, except in the event of design changes and other factors. A GMP may also include a provision enabling the developer to share in cost savings if the actual cost is below the price guarantee.
The lender typically has the right to pursue its default remedies if: (1) the borrower fails to commence or complete construction within the time periods specified in the loan agreement, (2) construction stops for an extended time period or (3) there is a loan default. Also, the borrower is required to deposit funds with the lender if the lender determines that the remaining unfunded loan commitment isn’t sufficient to complete the project or cover soft costs. Sometimes a lender funding demand may be mitigated by reallocating line items in the loan budget to take advantage cost savings.
Interest and Carry Guarantee
An interest guarantee covers interest, default interest and late charges accruing on the loan. An upfront interest reserve is established based upon the estimated interest charges on the projected funded amount through the construction and lease up of the project. Interest is therefore built into the loan budget and paid from this reserve. If the interest reserve is depleted or deemed insufficient to complete the project, the lender may require the borrower to deposit additional funds to replenish the reserve.
A carry guaranty is intended to cover operating costs of the property after completion of construction, during lease up. Such costs are for day-to-day management of the property, property taxes and insurance. A carry reserve may be established up front, in addition to the interest reserve.
These reserves may be reduced or released upon stabilization, subject to a debt coverage ratio test or other agreed-upon financial thresholds.
Construction loan guarantees, loan reserves and general contracts are complex and often intertwined. Lenders vary in how these provisions are structured – some are more flexible than others. Borrowers should work closely with financial professionals and legal counsel when negotiating these provisions to help ensure they are fair and reasonable in light of the risks involved.