Construction Loan Tips – Affordable Housing

CONSTRUCTION LOANS

Construction loan tips

By John Zipperer

Loan negotiation is a critical component that, properly carried out, protects the borrower and the lender as well as helps ensure a good relationship.

To give developers some tips on how to avoid construction loan legal problems and how to deal with them when they occur, Affordable Housing Finance spoke with two leading attorneys focused on real estate lending. A. Barry Cappello is managing partner at Cappello & Noël, LLP, a Santa Barbara, Calif.-based law firm and author of the book Lender Liability. He specializes in complex commercial litigation and lender liability. Richard S. Fries is a New York-based partner with DLA Piper Rudnick Gray Cary, where he represents institutional lenders and has been involved in loan origination, construction and permanent financing.

Q What are the biggest sources of problems between developers and construction lenders?

Fries: The biggest difficulties in the negotiations are misapprehension regarding budgets, requisitions, and the time frame for approval of requisitions. Typically the construction loan will be based upon an approved budget. Budgets change. There are cost surprises, and there are cost overruns and changes to deals, so budgets could invariably get out of balance. One of the things developers should do is make sure there’s a mechanism for the reallocation of costs, a certain built-in flexibility, where rather than a lender reducing availability under a loan because some construction costs are cheaper than others, the lender will reallocate those funds, appropriately and with documentation, to other parts of the job.

The second big one is requisitions under construction loans, [which] are typically made monthly. The developer or the construction manager will say, I need $200,000 next month for this trade. There is a built-in approval process in the loan documents. The developer oftentimes fails to tie the lender down to a reasonable time period for the requisition. It should be in the documents. If a lender does not respond quickly, the developer does not have the funds available for the trades.

Cappello: The biggest problems usually occur & where a lender has agreed to lend in phases. A big developer [may do] 50 apartments, and then another 160 apartments, and then a last phase. If the economy is fine, there’s generally no problem. But if it goes bad, the lender tries to back out of the agreement because he doesn’t want to lend the last phases. So in the loan documents for a variety of agreements, the bank’s ability to hop out of the loan becomes a critical point.

Oftentimes the agreements don’t have hop-out clauses for the bank, so the banks make them up. They have technical loan covenants, which have to do with things like the net worth of the borrower [and] nothing to do with whether the loan is being paid on time. But if the borrowers’ net worth falls below a particular level, or some oddball event occurs, the bank [then] seizes upon it to refuse to fund any further and perhaps calls the entire loan.

The second area is the [issue of requisition sign-offs]. Most good-size developers try to do everything not to have the lender in the middle of that process, but most construction loan [agreements include] a sign-off [from] the lender for the payments. That process has to be prompt, because the subcontractors on the project usually are not big guys and they’re looking to meet payroll.

Q With the steep increases in construction costs lately, it has become fairly common for developers to go back to their lenders for additional financing. Can they do anything in the original negotiation that will make it easier?

Cappello: The best thing the developer can do is be really realistic. If the costs are going up and they really know they can build it out if they make a new deal with the lender, that’s one thing. But if they’re kidding themselves, then they have to cut their losses. [In that case,] the best thing they can do is try to negotiate their way out, not necessarily try to hang onto the project. On the other hand, if the bank doesn’t want the project, then you just use it as a negotiating tool. OK, you don’t want to take it over, then give me a deal so I can build it out and survive.

Fries: The experienced developer knows how to build in that cushion. He is advised by construction managers and architects, and he is able to price at loan origination. There are two things that can be done: First, in the loan negotiations, a developer could request a line of credit that would be available [if] costs go up. That would be a separate facility & and would have to be collateralized. The [second thing is when developers and lenders are] surprised by costs. No lender wants a project that’s two stories in the ground. No lender wants a project where the trades are not paid and they file liens against the property. So the lender has to assess [if] the additional dollars make it more likely that the project will be completed and be ready for permanent financing.

Q What are the biggest mistakes developers make when negotiating construction financing?

Cappello: They sign a loan agreement that they guarantee. That’s nuts. Lots of times lenders will say you have got to do that, [but developers] shouldn’t be signing guarantees.

Also, a lot of out-of-state [lenders] are in this business now, and the loan document says this should be tried in [New York], and the parties agree that that’s where [any legal] case applies. They usually use New York law because New York law is so pro-lender that liability cases are very tough in New York.

So you have a California builder who signs a loan with a lender who’s got a New York jurisdiction clause and an arbitration clause. So no jury trial, and you’re in New York. There’s not a lot you can do about these clauses, but [you can get them stricken].

Q When reviewing loan documents, what are some issues the developer should watch out for?

Fries: Lenders like surveys. They want to know what’s going on with their property. The developer should try to limit the number of surveys requested by the lender to two  one at the beginning of the project and the as-built survey at the end.

Q A developer has defaulted on a loan. What are the options?

Cappello: You’ve got a lot of workout options. But the first thing you have to do is look at whether the lender has been involved in causing you to default. If the lenders’ actions by either not paying certain tranches or slow pay on the subcontractors are causing you the inability to service the loan, then you may have a lender liability claim. & They first have to find out if they have a lender liability case because the first thing the bank’s going to do is put a release in front of them in a workout case. As soon as that is signed, there’s no lender liability case any longer.

On the other hand, if you don’t have any lender liability issues, then your workout options are whatever you can negotiate with the bank.

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