GPSolo Magazine - September 2004
Real Estate Law
Construction Lending from the Ground Up
Construction lending is different in many respects from other real estate lending. It requires general knowledge of construction industry practices, engineering matters, and financing techniques. Although the pre-closing requirements are similar to other real estate loans, additional review is required to ensure that construction can commence and proceed without interruption.
Construction process and professionals: Architect, engineer, and contractor. The architect, engineer, and contractor constitute the triumvirate of professionals in the construction process. The developer begins with a tract of land and reviews the current zoning to ascertain the requirements that dictate the physical footprint of the planned project. The developer then has a rough idea of the square footage of improvements that can be constructed and can extrapolate the income potential.
The developer may take the general project design to an architect who will produce a set of plans and specifications, which can be distributed to a group of contractors for detailed pricing and contracting proposals. Construction contracts generally are based either on a fixed price or on the cost of construction plus a fee. The architect continues to serve as the owner’s representative and contract administrator, approving the contractor’s draw requests, monitoring the progress of the work, and inspecting the work for defects.
Construction lender’s pre-closing requirements from construction professionals. The construction lender requires three basic items from each professional. First, the lender wants assurance that if it needs to foreclose and remove the developer from the project, the professionals will provide continued service to the lender so as to complete the project on time and within budget. Second, the lender seeks confirmation that the project complies with all applicable governmental requirements and can be constructed and operated as planned. Third, if work has commenced before loan closing, the lender seeks assurance, by way of lien waivers and subordinations, that it has and will continue to have a first-priority security interest in the underlying real estate.
A project may involve one or more engineers. The civil engineer usually prepares the site, drainage, and utility plans. Once the plans are prepared, the engineer’s job is nearly complete. Therefore, although a continuation agreement can be requested from the engineer, it is not essential. But the engineer’s certification is required regarding site conditions, availability of utilities, acquisition of required permits, and compliance of engineering plans with all applicable governmental requirements.
Many projects require that the contractor be bonded and require as a condition to closing that a bond be issued in favor of the lender, usually under a so-called dual obligee rider to a payment/performance bond. The payment bond guarantees the payment of sums due under the construction contract to potential lien claimants. The performance bond generally covers performance of the work up to the full contract.
Many construction lenders require that building permits be issued before loan funding. This requirement may present a practical difficulty when the cost of the permits is high and is to be funded out of loan proceeds. One compromise is for the professionals to issue letters indicating that all requirements for the issuance of the permits have been fulfilled, except payment of the fees. A lender will usually agree to advance funds for closing on this basis, expecting the permits to be obtained expeditiously thereafter.
The project budget is the key component to the evaluation of the loan budget. It should detail construction on a line-item basis and should separately delineate all major components of construction, such as concrete, steel, masonry, interest reserves, marketing, or other fees. The budget should also have a realistic contingency line item. If there is a cost saving in a line item, then the lender will usually agree to move the savings to the contingency line item, to be used for other items at the lender’s reasonable discretion. If there is a shortfall in any line item, the lender may either use the contingency fund or require additional equity from the borrower. The construction loan agreement should provide that the failure of the borrower to provide the additional equity infusion is an event of default.
Construction loan agreement. In addition to the representations and warranties contained in most commercial real property loan agreements, a construction loan agreement should contain representations and warranties about the following matters: that the plans and specification delivered to the lender constitute a complete and final set of all plans and specifications required; that true and correct copies of the construction contract, architect’s contract, and engineer’s contract have been delivered to the lender; that the plans and specifications and the use of the project contemplated thereby comply with all applicable laws, ordinances, and regulations; that all utilities and rights of way necessary for the construction, use, operation, and maintenance of the project are available through public rights of way or through private easements; that all permits, certificates, and authorizations required for the project have been obtained; and that the borrower has not caused any labor to be furnished in connection with the construction of the project, or entered into any contract that could give rise to a lien against the project, except for parties who have been paid in full or have delivered lien subordinations or waivers.
The construction loan agreement will also contain certain covenants to allow the lender control over the construction process. Matters to which the borrower must agree include: to begin construction on a timely basis and to pursue it diligently to completion; to complete construction in accordance with all applicable laws, ordinances, rules, and regulations using sound construction practices and new materials; not to alter the plans and specifications without lender consent; to give the lender access to the project for inspection; to perform such tests as may be required by the lender; to correct defects in construction; to provide builder’s risk insurance; and to use loan proceeds solely for purposes allowed under the project budget.
The loan agreement will provide for specific instructions for drawing funds and include a list of conditions to be satisfied for each draw. These conditions include confirmation that: the total advances will not exceed the maximum loan amount; hard cost expenditures do not exceed the progress of construction on a percentage of completion basis; no potential or unmatured default or event of default exists; and the inspecting architects and lender believe that the construction is on schedule, can be completed on time, and has progressed in accordance with approved plans and can be completed within budget. Final disbursement at the time of completion may be subject to the lender’s receipt of: a final, as-built survey; a final contractor’s lien waiver; certificates from the borrower, architect, and inspecting architect; the appropriate occupancy permit or certificate of occupancy; approval and acceptance by any key tenant; and permanent casualty insurance.
Other key provisions provide additional administrative or oversight power to the lender. For example, draws should occur no more than monthly. The lender will typically withhold 10 percent of each draw request as retainage. It will also want the right to make advances to the title company or to third parties to ensure payment gets to those entitled to funds. The right to reallocate line items is often negotiated.
David A. Weissmann is a member of Weissmann & Zucker, P.C., in Atlanta, Georgia. He can be reached at firstname.lastname@example.org.
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- This article is an abridged and edited version of one that originally appeared on page 20 of Probate & Property, May/June 2004 (18:3).
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Real Property: The Commercial Lease Formbook; Expert Tools for Drafting and Negotiation; The Commercial Office Lease Handbook: New York Model Clauses and Commentary; Land Use Regulation: A Legal Analysis and Practical Application of Land Use Law, 2d ed.; Synthetic Lease Financing; A Practical Guide to Commercial Real Estate Transactions; Anatomy of a Mortgage; The Commercial Property Lease, vol. 3; Accessibility under the Americans with Disabilities Act and Other Laws; Land Surveys, 2d ed.