Make sure your clients’ projects stay on track.

Sometimes even the savviest lender can overlook the perils that lurk in the shadows of construction. Too often, projects go upside down when reasonable oversight, like having a baseline report conducted, would have saved the day. Even on deals that look completely safe, there are risks that private lenders should address.

Baseline reports provide lenders with a full overview of existing interior and exterior conditions of a structure before any construction activities begin. In addition, the intent of a baseline report is to provide a review of the contractor’s proposed scope of work, identify potential items of work that may have been left off the budget and bring attention to items that may be of special concern and may impact the cost or schedule for the project—all before the close of escrow. Overall, a baseline report provides the lender and owner with the information needed to make budget corrections, minimize cost increases and save valuable time before the start of construction. The following are just some of the ways to minimize risk.

Documents Needed

In an ideal situation, before a lender agrees to fund a new construction project, all plans and budget documents should be reviewed and analyzed to verify completeness and quantify amounts. The items needed to get a baseline report started might include a full set of plans, any signed contracts or bids, complete project specifications, a schedule of materials and a complete budget for the project. Of course, any additional items that can be provided for in the baseline report will only add to the thoroughness of the analysis.

Some of the typical results of baseline reports include necessary line items not included in the budget, rate increases for products that were not factored at current levels (such as when the costs of copper or asphalt skyrocketed due to economic changes), or when labor costs are established by “friends donating time to help out” and not by utilizing market rates.

Budget Review

The borrower should submit a complete line-item budget and a set of approved plans. You, as the lender, can then hire an independent, third-party firm to verify and valuate line-item costs by consulting construction-cost databases and subcontractors. The budget review will show you if quoted prices are in line with the norm for that area and whether they reflect the true cost of construction.

A budget review will give you and your borrower an opportunity to identify missing costs before construction begins. Make sure that funds are set aside for unforeseen issues. A project can fail if there is no “cushion” for contingencies. Typically, contingencies account for 10 percent
of the overall budget.

Construction Schedule

A clear scope of work defines the extent of work necessary to complete the project. Your borrower’s contracts with remodelers and other contractors should require a schedule that spells out when the project will be completed. Without this language, delays can result for both the borrower and the lender.

Get the details. When will the project start? Who pays when there is a delay? Is the timeline for construction in line with the loan time? Does the schedule account for weather and product availability? Get these questions answered before the project begins.

Insurance and Licensing

All contractors and subcontractors on the job site should provide proof of insurance. Subcontractors who are severely underinsured represent a significant financial threat. Also, review all licenses for contractors and subcontractors.

Permits

No work should be done without permits. If work is started without a permit, the project can be halted by city or county jurisdictions until a permit is pulled. And, if a permit is not issued, it could still be discovered and lead to the new owner receiving a red tag from the city, leaving the borrower responsible even after the close of escrow.

Change Orders

Change orders are typically handled at the site level between the owner and the contractor; however, a project’s change-order documents should be included with each draw-request submission to the lender. This will keep the lender informed of any changes to the original scope of work. Change orders should be monitored closely so there is not a significant increase in project costs.

Lien-Waiver Documents

For the property owner’s and the lender’s benefit, all appropriate lien-waiver releases should accompany each draw request. Some lenders pay off invoices immediately. Others pay when materials are on-site. And others pay only when the materials are installed. Lien waivers that are not traced and cleared can result in double payment by the owner, as well as delay or impede sales.

Progress Payments

Progress payments should only be made at agreed-upon times. All receipts, deposits, copies of permit cards and other relevant documents should be included with requests for pay.

Typically, borrowers submit their request to the lender, who then processes it and forwards it to the inspection company, which in turn gives the field inspector a complete checklist to review at the job site. The inspector’s duty is to verify the progress-to-date against the application submitted. Do not advance project funds before work is completed.

Investing always has its risks, but applying comprehensive risk-management oversight, especially with help of an independent, third-party inspection company, can protect a lender and help ensure a successful, profitable investment.

It’s All In The Budget

In the current lending environment, lenders are being held to tighter underwriting requirements. Limiting risks of portfolios and taking a more thorough look at project costs and overall feasibility is necessary before handing builders and developers hundreds of thousands or even millions of dollars. In many situations, these requirements should be mandatory for protection of investors and lenders. Because of time and cost constraints, many construction lenders have been opting for estimates produced from sketchy square foot historical data. They do this rather than bear the expense and time required for a more detailed analysis using developed takeoff information for verification of construction costs.

Square Foot Estimate Vs Takeoff Estimate

All budgets are created equal, right? In a perfect world, maybe. While there is some validity and wide range use of the square foot (SF) method of estimating, it does not serve the needs of construction lenders who are looking for higher levels of assurances for the cost required to construct a project.

These two approaches are exactly what they claim to be. They are a dichotomy in their approach and their meaning.

The square foot estimate method is a much faster and cheaper way to generate costs and will provide an approximate idea of feasibility, but it is not an accurate method to generate actual project costs. It is generally used in conceptual budgets in the early stages of project development, but that is usually where it ends. It is a quick reference tool based on historical data; however, it does not consider items such as design details that slow down production, items such as vaulted or higher ceilings, specialty interior or exterior finishes, enhanced levels of quality, building geometry and design elements.

In addition, construction that must be done under the pressures of a deadline or in adverse weather conditions, or even rebuilding after a fire or other major catastrophe, or in a challenged labor market, can temporarily inflate costs substantially. Because SF estimates do not take these important factors into consideration, SF budgets are ultimately unreliable in predicting actual construction costs in the real world. The cost per square foot should be considered as a general barometer used to get a ballpark idea of cost. It is not an accurate estimate of cost.

The takeoff estimate method produces a much more accurate estimate. This method allows you to start the task with a thorough understanding of the building project and its specific elements, quantifying each component in a construction project before determining the cost to construct. This method utilizes local cost databases with verification from suppliers, installers and tradesmen. It also considers quality of construction materials and finishes, building shape, floor area, material usage and special design elements specific to the project. The takeoff estimate will always cost more to produce than a SF estimate, because it requires additional time for accuracy and detail. When your business and profitability depend on accurate information, it is the approach that should be implemented. How do you justify spending valuable time generating or defending inaccurate information?

Estimating is both an art and a science. The science comes from approaching the estimate in a methodical, meticulous, organized and orderly manner. The art comes from being able to imagine how the project will be built in the location, including the means and methods involved in starting from the ground and working to the top. The experienced and knowledgeable estimator will apply both art and science in generating reliable cost information to produce an accurate and reliable baseline report.

The use of unbiased third-party inspectors has become increasingly vital to lenders nationwide. Third-party audits from independent companies provide an invaluable component—a check and balance for your risk management. Additionally, using qualified third-party inspectors offers another opportunity to analyze the project to keep each construction project on schedule and within budget. With the construction climate’s dramatic changes, it is extremely important to use qualified professionals to help you through your construction lending projects.