The New BFFs: Construction Lenders, Contractors
Changes in the sector merit a re-evaluation of traditional relationships.
Construction really took a hit with the downturn in the economy. It is now starting to show signs of life, and everyone in the industry is cautiously optimistic and … nervous. Recent experiences have reminded us that if a construction project doesn’t get completed, everyone loses. Chief among the losers are the financial institutions who lent the money to finance construction, and the contractors, subcontractors and material suppliers who performed the work to get it built.
Historically, lenders and contractors have been kept at arms’ length from each other, separated by their mutual customer, the developer-owner. They got into the habit of expecting the other to so deliberately put his own interests first that they felt they needed to protect themselves, lest they be mowed down. But lenders and contractors not only have a lot in common—they also can help each other to assure a profitable construction project.
Lenders and contractors want to make sure that the owner/borrower is sophisticated, and appreciates the scope of the project. A naïve, inexperienced customer is a train wreck waiting to happen. Construction is an inherently risky business. In few other businesses is success so dependent on good weather, on-time deliveries, competent workers showing up when needed and uninterrupted cash-flow. The lender and the contractor will need to feel comfortable that the owner fully understands the local permit, code and inspection process.
Lenders and contractors want to make sure that the owner/borrower has enough money to finish the work. This means having complete plans and specifications, a realistic budget, and a contingency fund to cover unpredictable (but likely) extra costs. The involvement of all three parties in development of the budget and scope of work and the administration of the budget during construction can ensure that the sufficient funds will be available to cover necessary costs.
Lenders and contractors want to make sure that ALL the bills are paid by subcontractors and suppliers. Lenders HATE mechanic’s liens, as do contractors, because it means that the system of checks and balances broke down and someone didn’t get paid. The lender wants its title company to be able to “date down” its title insurance coverage (including mechanic’s lien coverage) in connection with the construction loan advances, so that it has as much security against liens as possible. The general contractor wants to avoid claims from people he’s never heard of who claim that subcontractors haven’t paid their bills.
Lenders and contractors want the project finished on time. The lender wants its customer to have enough resources to cash-flow interest until maturity of the construction loan and wants its construction loan timely replaced with permanent financing. The contractor knows he never makes money by having projects drag out and wants to avoid a default under the construction loan on account of the completion date requirement not being met.
So, how can lenders and contractors work together?
Get consent from the owner/borrower to share information. By allowing the contractor to know how much is in undisbursed construction account at any given time, and allowing the lender to review lien waivers and change orders and verify receipt of payments by suppliers, these two parties can help each other to keep the project budget within the available funds, and see that everyone gets paid.
Have the right to understand all deals struck. Lenders and contractors have an interest in seeing that the owner/borrower has clear and legally binding contracts that don’t impose unreasonable restrictions on other’s rights.
Have a clear understanding about “priorities.” Anyone who has been in this business for any length of time has his or her own horror stories of being left with “the fuzzy end of the lollipop,” as Marilyn Monroe put it, and understands the importance of having a mortgage lien and security interest in the work. Someone’s interest, however, has to come first. This is a complicated area of law, but there is no reason that either side should end up surprised.
Agree on the process for making payments for the work. This also includes getting agreement on forms for mechanic’s lien waivers and who will have to give them (including vendors of materials), and what paperwork will have to be submitted and approved prior to issuance of any payments.
Agree on the lender’s rights if the owner/borrower defaults. Virtually every lender wants the contractor to sign a “Collateral Consent to Assignment” of the construction contract, so that the lender has the right to get the project completed. Most contractors have no problem with this concept, but they are very leery of these sometimes scary-looking forms. What they really care about is getting paid, however, and it is best for all to confront problems right away rather than end up in a fight after an owner defaults.
The more the lender and contractor know about the entire structure of the project, the more they can do what is in everyone’s interest: assure that the project is successful for all.
Don Kirkpatrick is a partner in Stinson Morrison Hecker's Financial Institutions Practice Group.
P | 816.691.2409
E | DKirkpatrick@stinson.com
Susan McGreevy chairs the firm's Construction Practice Group .
P | 816.691.3480
E | SMcGreevy@stinson.com
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