Stay Safe From the Terrors of Construction Lending
If there’s one question that I get asked more than anything else, it’s ‘Why?’.
Why couldn’t you fund this deal? Why won’t anybody else fund this deal? Why did my bank tell me that they’re no longer funding construction? (From the new loan officer at the bank) Why did my boss tell me not to fund construction?
The short answer is: Construction is scary.
In most commercial lending spaces, the big risk is insolvency: So long as the account debtor stays in business, and the work has been performed, the right people will get paid. That’s a gross oversimplification, of course, but it more or less holds true across industries–that’s why credit insurance is such a useful buffer against risk.
Construction, on the other hand, is a world unto itself.
You have a long and sometimes complicated payment stream that includes the project owner, the project owner’s bank, a general contractor, first tier subcontractors, second tier subcontractors, third tier subcontractors, and suppliers for all of those subcontractors. You have architects and engineers and project managers who can disrupt the flow of the project at any time. You have delays caused by unrelated parties. You have disputes about whether work was performed properly, and what the true scope of work was, and who should be on the hook for unexpected conditions that arise.
Moreover, all of these variables come with big price tags: When things go wrong on a residential mortgage, it’s generally a $300k problem, with a $300k house as collateral. When things go wrong in commercial construction, it can easily be an $15M problem, with no finished product to turn to for security.
Because of all of these issues, when it comes to construction, you can’t just write a check and call it a day.
In order to safely fund, you (1) Have to know at least a little about construction, (2) Have a very solid grasp on what the overall project looks like, including knowing who every party both upstream and downstream is, as well as the various contractual loopholes could cause problems in the event of dispute, and (3) Keep a constant eye on the project, since things can go from ‘running smoothly’ to ‘multi-million dollar pile of useless beams and unlaid bricks’ within a matter of days.
This that means that for most lenders, construction just isn’t a wise risk.