Here are 5 tips for optimal construction loan risk management. Here is everything you need to know
The demand for new housing has skyrocketed in the US in recent years. With that need growing, there is an opportunity for lenders to provide construction loans.
But construction lending can be risky. Lenders must ensure that construction is on schedule and on budget. Lenders also need to ensure that the construction loan is paid back on time. That is where construction loan risk management comes in.
In this article, we will look at construction loan risk management, which risks to look out for, tips for avoiding risk. Here is everything you need to know.
What is construction loan risk management?
Construction loan risk management is a process or system used to identify and reduce different risks within a construction project. With construction loan risk management, you would also evaluate the impact of these risks and implement procedures to mitigate their financial impact on the business.
By using this process, construction firms are better able to predict and minimize the likelihood of any issues that arise. It can also help firms maximize rewards.
Construction loan risk management involves numerous tools. However, the foundation of a successful program is built on data. This type of data comes in multiple forms. It can be internal cash-flow statements, economic reports, and job-site safety analyses. In other words, a company can maximize results and minimize risk by collecting and analyzing data on past performance.
Construction loan versus traditional mortgage
A construction loan is a short-term loan covering only the costs of custom home building. A construction loan is different from a traditional mortgage; it is considered specialty financing. After construction on the house is complete, the occupant must then apply for a mortgage to pay for the property.
There are several important differences between a construction loan and a traditional mortgage. For starters, construction loans are usually no longer than a year in length.
Traditional mortgages, on the other hand, are long-term loans (typically 15 to 20 years). With a traditional mortgage, you would receive the money in a lump sum. When closing on the loan, the mortgage repayments start immediately and consist of both interest and principal.
For construction loans, you typically make interest-only payments during the completion of the construction project. And because they are considered a greater risk for lenders, construction loans also tend to have higher interest rates than most traditional mortgages.
What is a common risk in construction lending?
In every construction loan program, there are common risks involved. If, however, you have strong construction loan risk management in place, these risks should be a non-issue. While there are many risks involved in construction lending, one major one is non-completion of the project or house within the specified period.
Funds can run out before the end of the construction project if the budget is improperly managed. This scenario is common to all parties involved. However, it is particularly risky for the mortgage lender. To prevent this, you must ensure that your construction loan holdback is managed correctly.
Builders should never get more money than is supported by the percentage of work they have completed. This can be verified by the construction progress inspection. It also highlights the importance of draw inspections for maintaining balance sheets. This should be done all the way to the end of the project.
In this case, the lender can ensure the following:
- The construction loan is in balance through to the end
- The undisbursed money remains adequate to finish the improvements
- Draw disbursements are released for finished work only
5 tips to improve construction loan risk management?
Construction loans have taken off in the last few years. Between the new offerings and the previously existing renovation loans, investors have numerous options to choose from. However, it depends on the type of property and the scope of the project that they’re willing to undertake.
In other words, the demand is there. But that doesn’t mean that everyone involved in the transaction of a construction loan knows as much as they should. There are risks. Let’s look at tips for construction loan risk management.
- Do your due diligence on the lender
- Ensure you are working with construction professionals
- Find a reliable contractor
- Do your due diligence on the contractor
- Avoid relying too heavily on tech
Let’s break down each of the risks to help you improve your construction loan risk management.
1. Do your due diligence on the lender
For residential originators, it’s risky 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 are different than those in Oklahoma City. That should be taken into account when determining the draw schedule.
2. Ensure you are working with construction professionals
Construction is about building. But it is also about logistics. Because there are so many moving parts, it is important to work with someone who has knowledge of the different stages of the project. They should also know how much time each stage will take.
Inexperienced contractors are likely to get the budget wrong from the start. Remember: once the loan is funded, there is no way to start over without getting an entirely different loan. This is because you will have already made a credit decision on existing loan parameters.
3. Find a reliable contractor
Just because you received a bid from a contractor, it does not necessarily mean the work will be done quickly, done well, or done at all.
“The guy doesn’t have to finish it,” said Brian Mingham, founder and CEO of CFSI Loan Management, which is a nationwide construction risk mitigation firm. “He can walk away from the job if it’s not profitable, and the originator has a half-built house. … There’s massive opportunity for loss across the board.”
Hiring an unreliable contractor may also lead to having to fire the contractor midway through the project. This may cause two other major issues, with budgeting and timing.
4. Do your due diligence on the contractor
When hiring a contractor, you should ask questions. Is the contractor licensed? Are they uninsured? Are they experienced enough to notice the expected budget is way off? You should take the extra time to speak with the contractor’s suppliers and tradespeople. This will likely tell you how well they communicate and how well-established their partnerships are.
For instance, a contractor may have been paid, but maybe there are issues paying their sub-contractor, which 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,” Mingham said. “But things happen.”
Want to improve your construction loan risk management? Do your due diligence with the contractor.
5. Avoid relying too heavily on tech
It is best to avoid relying too heavily on technology, especially when it comes to budgets and inspections.
“(Technology) 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,” Mingham said. “It doesn’t know that the prices are right—just knows that there’s prices. It doesn’t know that there’s missing information. … Technology doesn’t catch that; experience catches that.”
For instance, CFSI works with lenders during underwriting to determine which projects are feasible. At the back end, they help manage the budget, draw inspections, and collect documentation on residential, commercial, and multifamily projects.
“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.”
Construction loan risk management: closing thoughts
Before taking out a construction loan, it is important to understand the different risks involved in a project. With sound construction loan risk management, you not only mitigate risks involved with scheduling and budgeting. You also evaluate the impact of these risks and implement procedures to mitigate their financial impact on the business.
Remember: doing your due diligence with the lender, contractor, and construction professionals is critical to improving your construction loan risk management.
To find out more about construction loan risk management, get in touch with one of the mortgage professionals we highlight in our Best in Mortgage section. Here you will find the top-performing mortgage professionals across the USA.
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