Never let the truth get in the way of a good story.” Those are the words of great American writer Mark Twain. And his meaning is well taken. What do friends do when they are out to dinner, on a long road trip, or sitting by a roaring campfire? They tell tales. Some are actually based in fact, and others are, well, rather tall. But the listeners don’t care. They hang on every word because they want to be entertained. After all, who doesn’t love a good story?

Loan underwriters, that’s who. If a deal goes belly up, will company stakeholders be encouraged by a hopeful anecdote that made its way to the investment committee? Absolutely not.

Underwriters are your first line of defense against deal failure, so cold facts win the day in their world. The same is true for servicing and asset management, but by that point in the deal, a loan’s course is already charted. This puts a lot of pressure on the underwriting discipline to be nearly flawless.

Three Pillars

With ground-up construction (GUC), there is even less room for error than your typical bridge loan for a transition property going through a rough patch toward stabilization. A soon-to-be rental property, apartment building, or mixed-use development is an exciting concept, but it’s still just a concept. It has no existing rent roll to fall back on, no established client base, and no quality craftsmanship already drawing the target demographic. It is especially critical, therefore, that the lender on any blank-canvas new build has institutionalized fact-based lending. From the first point of contact with a prospective borrower, your originators and underwriters should have blinders on for three pillars of any successful GUC loan:

1. Good collateral
2. A clear takeout
3. A worthy sponsor

Everything else is just ambient noise.

Collateral. It is easy for a loan originator, in particular, to be caught up in how the opportunity with the subject property came to be. When you hear “you’re not gonna believe this,” it’s time to put your guard up. Maybe the subject was an eyesore for years and was finally rezoned once the municipalities cried “Uncle.” Perhaps it was once owned by the granddaughter of a famous industrialist. These days, it might even be rumored to have a surf park developer kicking the tires up the street.

All these stories are very interesting, but they are not germane to the project at hand. What is the collateral, by itself, right now? Is it located at the corner of Main and Main, with established traffic patterns, in a primary market? Or, is it just outside the loop, in a secondary market? If you end up with it, what are you really ending up with?

Assuming the location is good, what was used to determine “as-is” and “as-complete” values? Was it an independent appraiser (hopefully) or a drive-by and some Zillow comps (hopefully not)? Is a feasibility study warranted? If so, was it secured by a reputable firm? In the event of foreclosure, can the subject be easily repurposed? A lender cannot be too careful in determining what the collateral is today, what it’s truly worth, and how flexible its use is.

Takeout. Because the loan exit strategy is the last thing to happen chronologically, a not-so-seasoned lender might let if fall to the bottom of a prequalifying checklist. It is the second pillar mentioned in this short list of three, but it could just as well be first. “Bridge lending,” by definition, has a destination in mind. The loan will take the project from point A to point B, so consider the endgame as early in the process as possible. Is the buyer under contract for the finished product, with earnest money in escrow? How many backup buyers are queued up? Or is it being built on spec (gutsy!)?

Admittedly, sometimes the loan exit plan changes for valid reasons (e.g., buyer default, availability of materials, a pandemic). As long as there is a clear plan to begin with, adjustments can be made for reasons outside your control. If you’re taking your family on vacation, you can adjust the route or mode of travel, but you probably wouldn’t pack everybody up and hit the road with no idea where you’re going, right? A lender must know the destination to which their loan is taking all the parties involved. You should update and maintain the certainty of takeout just like you guard against prohibitive LTV—with your life.

Sponsor. The sponsor is the driving force that will take the collateral (Pillar 1) to the “takeout Promised Land” (Pillar 2). This individual, or team of co-sponsors, will make or break any deal. How much equity do they have invested in the project? Are they trying to claw most of it back with their first couple of draws, or is it truly committed? How many projects of comparable size have they successfully exited? Is their general contractor vested in the project, or are they a third party? What does the sponsor’s REO portfolio look like?

It might sound crazy, but there can actually be a little wiggle room with the sponsor pillar, as long as collateral and takeout are rock-solid. For example, if they’ve done several smaller GUC projects and this is their first time managing multiple parcels, that’s not a huge leap. If collateral and takeout pass muster, this could be a great opportunity. Even if the sponsor has failed at one time or another, they can still buy your confidence by showing what they learned and how it changed the way they do things. If they don’t come from a long construction background, that’s not a deal-killer as long as they’ve mobilized a strong team of experts and garnered the municipal support necessary to see the project through.

Other GUC Factors

There are several operational factors unique to ground-up deals that are worth mentioning, as long as the Three Pillars are maintained:

Construction Plans and Budget. If you don’t have a robust department for this already, have a third-party consultant verify the architectural plans and corresponding budget to ensure everything has been addressed.

Draw Maintenance. After plans and budget are verified, agree on draw frequency and what the process looks like for the sponsor. Some firms manage this in-house, but several reputable third-party platforms exist as well.

Bonds. The bigger the project, the more important completion and performance bonds are to have in place. You can’t have too many assurances and redundancies.

Insurance. Depending on the geography and the nature of construction, insurance should include certain coverages that should not be overlooked. Pay close attention to the declarations and exclusions.

Standardize for Success

So, how do you institutionalize the Three Pillars to prevent being swayed by just another compelling story? To succeed over time, this troika should be prominent throughout the organization. Originators, for example, can be kept between the lines by hard-coding requirements in your CRM and by eliminating certain property types from being options at all. If you force adequate prequalifying by your front-line sales team, it safeguards against poor decisions and also aligns them with underwriting.

As for your underwriters, they must be able to recite the boilerplate requirements in their sleep. Even the owners should sign a blood oath to set the right example and not force exceptions into the pipeline simply because they played golf with the owner of a “diamond in the rough.”

At every chance, celebrate loan redemptions with the team and draw attention to the standards that were maintained prior to funding. The best teachable moments come with loans that required a lot of discussion about a shortcut that was denied. For example: “The originator really wanted to fund this loan, but we held off until the takeout plan was defined in greater detail. Because we held to a high standard, everybody has another skin on the wall and funds to redeploy.”

In the current financial market, where interest rates have risen to forgotten heights, developments still need financing. Marginal projects may have moved to the backburner, but market by market, it is business as usual for builders and developers who are sitting on hallmark projects. With institutional sources taking a hiatus, this is the perfect scenario for well-capitalized private lenders. Every business has a story to tell. Stick to the fundamentals, and your story will be spectacular.