Construction loans: risks when the construction industry is in distress

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The current state of the construction industry

The global construction industry is undergoing a period of considerable uncertainty, largely as a result of the COVID-19 pandemic and its by-products, and more recently the impacts of the war in Ukraine.

Since 2020, global construction output has fallen by 3.1% (in contrast to 3.0% growth in 2019).

Supply chains are in crisis, with builders and developers finding it increasingly difficult to source basic materials from domestic and international locations. This is driving the price of materials up, as demand rapidly outpaces supply.

This issue is being compounded by labour shortages, with self-isolation requirements and a lack of temporary migration straining the ability for projects to run to schedule.

As a result, construction firms are finding it increasingly difficult to keep a positive cash flow, and a number of Australian construction companies have collapsed.

How does this affect lenders?

These challenges impact both the commercial and residential building industry, and can pose considerable risks to the enforcement and recovery of loans and security properties.

It’s important that lenders are aware of the risks associated with construction loans, and how to mitigate them, as the current pressures on the construction industry are predicted to worsen.

How can lenders mitigate the risks associated with construction loans?

1. Pre-approvals

Lenders should verify the projected costs of construction to ensure that borrowers will be able to meet their contractual obligations, having regard to potential further increases in material and labour costs.

Documents can be collected from borrowers and other parties involved in the project to help lenders assess the viability of a project / the risks of non-completion.

Documents lenders can collect prior to approval include:

  • a copy of any relevant permits, including plans and specifications approved by the relevant authority;
  • a copy of the building contract, including all variations and the progression payment schedule;
  • home owners warranty insurance (where applicable);
  • builder’s ‘all risk’ insurance policy and the certificate of currency of that policy; and
  • a copy of the survey report completed by a licensed land surveyor.

2. Progressive drawdowns

Most lenders opt for a progressive drawdown structure to provide them greater control in allocating funds and making sure they are being used for construction.

For more certainty, lenders can mandate that payments are made directly to third parties such as builders, and loan agreements can oblige borrowers to provide a valid building insurance policy (with the lender noted as an interested party) before the final progress payment is made.

Lenders may wish to physically inspect work sites to confirm that work specified in progress claims has in fact been completed.

A lack of drawdowns by borrowers may be a red flag that a project is stalling. Lenders should proactively record and monitor the frequency of drawdowns to help identify projects facing challenges.

3. Adhere to the terms of the loan agreement

Construction loan agreements generally confer a number of rights to lenders, which can be exercised over the term of the loan, to mitigate the risks of the loan.

For example, if the loan agreement states that construction must be commenced and/or completed within a certain timeframe, the lender should be checking that these conditions are met, and considering its options if not (which may include for example, the right to refuse further advances, or to call default and call up the loan).

Adherence to these types of conditions (and other construction loan terms) are also important because some funders will set strict time limits for construction loans to be eligible for funding.

It’s important to be aware of the serious consequences that can flow if borrowers fail to meet timeframes imposed by third parties for commencing and completing construction, for example:

  • by governments under grants of leasehold title - where the lease may be terminated, effectively negating the lender’s security; or
  • by developers under land package contracts – where ‘buy-back’ provisions may be enforced, requiring the borrower to transfer the property back to the developer.

Generally lenders have the right to inspect construction sites to ensure that construction is proceeding satisfactorily. While traditionally lenders have not committed resources to enforcing this right, lenders may wish to conduct site inspections in some cases – for example, where lenders have reason to believe borrowers have fallen foul of their obligations under the loan agreement.

4. Adjusting valuation metrics

Now is a good time to consider and adjust property valuation metrics to ensure that these take into account the increasing costs of materials and labour shortages in the market.

Next steps

Lenders should take proactive steps to manage their construction loan portfolios in these times of uncertainty. Given the current climate, it has never been more vital to ensure that construction projects are being funded appropriately and running on time.

Accordingly, now is a good time for lenders to review their portfolios to flag any accounts of concern and consider possible remedies, and also consider whether it is appropriate to amend their credit policies for new construction facilities.

Where lenders are going to act on construction loans, it is important that appropriate notice is given to customers, and in some cases, advance notice may actually be mandated by the loan agreement.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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