5 of the most common risks when doing construction loans

by Kimberly Greene05 Aug 2019

Inexperienced investors can overlook the risk involved with construction loans, but when it comes to investment properties, sometimes buying the property is the easiest part.

Construction loans have taken off like gangbusters in the last few years. Between the new offerings and the previously existing renovation loans, investors have any number of options to choose from depending on the type of property and the scope of the project that they’re willing to undertake.

Brian Mingham is the founder and CEO of CFSI Loan Management, a nationwide construction risk mitigation firm. He says that everybody is looking at 203k loans, which are generally simpler to do, in part because they tend to be smaller and easier loan programs to navigate. Ground up construction, however, is a little more complex because a lot of the financing solutions and products haven’t been out there for that long. Most importantly, Mingham says, there might be some hiccups when it comes to getting the warehouse bank to agree that they’re going to allow the lender to have a loan on their line for 12 months. To get that done right, that takes a little more time from an investor perspective, and there’s more risk involved.

The demand is definitely there and doesn’t show signs of abating anytime soon, although that doesn’t mean that everyone involved in the transaction of a construction loan knows as much as they should about the loans in question. There are different risks for different types of borrowers, and there are some risks apply on a much broader scale.

Risk #1: Not doing due diligence on the lender
From a residential originator perspective, Mingham said, a big risk is not going to someone who specializes in construction loans and assuming that the underwriter knows how to write a construction loan. Most lenders are approved in multiple states, but construction costs in New York City construction costs are different than those in Oklahoma City, and that should be taken into account when determining the draw schedule.

Risk #2: Starting a project without any experience
“The ability to think that a lender can manage the construction with no construction experience is the biggest mistake that people make, and then not collecting documentation, and ending up with liens and a busted project, as well as everything else,” Mingham said.

Construction is about building, but it’s also about logistics. There are so many moving parts in a construction project, and managing the project requires some knowledge of the different stages in the process and how much time is necessary for each stage.

Contractors with little to no experience are more likely to get the budget wrong from the get-go, and once the loan is already funded, there are no do-overs without getting an entirely different loan because the person has already made a credit decision on the existing loan parameters.

Risk #3: Thinking that hiring a contractor is a done deal
It ain’t over ‘til it’s over, and just because a borrower has gotten a bid from a contractor doesn’t mean that the work will be done quickly, done well, or done at all.

“The guy doesn’t have to finish it; he can walk away from the job if it’s not profitable, and the originator has a half-built house. The scratch and dent on a half-built construction loan is probably 20 cents on the dollar, versus a scratch and dent where you missed somebody’s FICO score by a point,” Mingham said. “There’s massive opportunity for loss, across the board.”

There are plenty of times that a borrower will fire a bad contractor mid-way through a project, which instigates another set of issues, including the two big ones: budgeting and timing. The next person that puts in a bid may be better, they may be worse, they may be busier, they may work slower, and/or they may cost more. Hiring a contractor is not necessarily a set-it-and-forget-it type of task.

Risk #4: Not doing the proper due diligence on the contractor
A bad contractor and a bad bid start off a bad project, and there are plenty of ways it can things can go south from there. Is the contractor licensed? Are they uninsured? Are they experienced enough to notice and speak up that the expected budget is way off for the scope of the desired work? Taking the extra time to talk to the contractor’s suppliers and tradespeople, for example, may seem unnecessary, but can glean valuable information when it comes to whether or not they communicate well and have well-established partnerships.

A contractor may have been paid, for example, but they aren’t so great when it comes to paying their sub-contractor, who still has lien rights.

“People skip [lien release] paperwork all over the country because they think that they don’t need it, or that their contractor wouldn’t do that to them. But things happen,” Mingham said.

Risk #5: Assuming that tech is the answer
Technology has its place, but it can’t replace the work of experienced professionals in the space.

“It doesn’t know if the budget is accurate for a high-rise condo in New York City versus a high-rise condo in Des Moines, it doesn’t know that the prices are right, just knows that there’s prices. It doesn’t know that there’s missing information, so if you go through a budget and there’s no roof, it doesn’t know that there’s no roof,” Mingham said. “The manipulation of budget, when you have a clerk that just puts an item in whenever somebody changes it, technology doesn’t catch that. Experience catches that.”

Construction risk management firms like CFSI are becoming increasingly popular as the fervor for construction loans continues. CFSI works with lenders during underwriting to help them determine which projects are feasible, and on the back end, helping manage the budget, do draw inspections, and collect documentation on residential, commercial and multifamily projects across the country.

“It’s risk management,” Mingham said. “We go out and physically inspect the property, and physically tell the person that everything that they’re asking for is done, the permits are signed off and we’ve collected all the lien releases. That is construction risk management and a clerk in a mortgage company that originates in multiple states does not have the experience to manage that process. It’s impossible. They just don’t have it.”