In the US, the demand for new homes has surged dramatically in recent years. Lenders have a chance to fill the growing demand by offering construction loans.
Yet lending for construction can be dangerous. The timeliness and budget of the construction project must be monitored by lenders. Additionally, lenders must guarantee that the construction loan is repaid on schedule. Construction loan risk management can help with that.
This post will discuss construction loan risk management, potential hazards to watch out for, and risk-avoidance strategies. Everything you require is provided here.
What is risk management for construction loans?
A method or system called construction loan risk management is employed to recognize and minimize various risks in a building project. You would assess the risks associated with construction loans and put policies in place to lessen their financial impact on the company.
Construction companies are better able to anticipate and reduce the possibility of any problems by employing this procedure. It can also assist businesses in maximizing profits.
Risk management for construction loans requires a variety of tools. But data is the cornerstone of any successful program. There are various formats for this kind of data. Economic reports, job-site safety assessments, and internal cash-flow statements are a few examples. Put another way, by gathering and examining data on historical performance, a business can optimize outcomes and reduce risk.
Construction loans as opposed to conventional mortgages
A construction loan is a type of short-term loan designed exclusively to pay for the building of a custom home. A construction loan is categorized as specialty financing, which sets it apart from a conventional mortgage. The occupant of the house must then apply for a mortgage in order to pay for the property after construction is finished.
A construction loan differs significantly from a conventional mortgage in a number of ways. To begin with, construction loans typically have a maximum one-year term.
On the other hand, conventional mortgages are long-term loans, usually lasting 15 to 20 years. The money would be given to you in one lump payment if you had a conventional mortgage. Mortgage repayments begin immediately upon loan closing and include principal as well as interest.
Normally, interest-only payments are made on construction loans while the project is being completed. Additionally, construction loans typically have higher interest rates than most conventional mortgages because lenders view them as a greater risk.
What kind of risk is typical for construction loans?
Every construction loan program has a standard set of risks. However, these risks ought to be negligible if you have robust construction loan risk management in place. Construction loans carry a number of risks, but one of the main ones is that the project or house won’t be finished by the deadline.
If the budget is not properly managed, money may run out before the construction project is completed. This is a situation that all parties share. That is risky, though, especially for the mortgage lender. You need to make sure that your construction loan holdback is properly managed in order to avoid this.
It is imperative that builders never receive more money than their percentage of completed work justifies. The construction progress inspection can confirm this. It also emphasizes how crucial draw inspections are to the upkeep of balance sheets. This needs to be carried out through to the project’s completion.
The lender in this instance can guarantee the following:
- Up until the very end, the construction loan is in balance.
- The remaining funds are sufficient to complete the improvements.
- Draw payments are only made for completed work.
What are some suggestions to enhance the risk management of construction loans?
In the past few years, construction loans have become very popular. Investors have a wide range of options between the newly available loans and the renovation loans that were already available. It does, however, depend on the kind of property and the extent of the work they are prepared to do.
Stated differently, there is a need for it. However, this does not imply that all parties to a construction loan transaction are as knowledgeable as they ought to be. Risks exist. Let’s examine some advice for managing the risk of construction loans.
- Check the lender out thoroughly.
- Make sure the people you work with are experts in construction.
- Locate a trustworthy contractor.
- Make thorough investigation of the contractor.
- Don’t rely on technology too much.
To assist you in better managing the risk associated with construction loans, let’s examine each risk in more detail.
1. Research the lender thoroughly
It’s dangerous for residential originators to assume that the underwriter is capable of writing a construction loan and not to consult with a construction loan specialist. Although most lenders are approved in multiple states, Oklahoma City and New York City have different construction costs. That is something to consider when deciding on the draw schedule.
2. Verify that you are collaborating with experts in construction.
Building is the focus of construction. But logistics play a part as well. There are a lot of moving components, so it’s critical to collaborate with someone who understands the various project phases. They ought to be aware of how long each step will take as well.
It’s likely that inexperienced contractors will start with the incorrect budget. Recall that once the loan has been funded, it cannot be refunded unless a new loan has been obtained. This is due to the fact that you will already have chosen your credit based on the terms of the current loan.
3. Locate a trustworthy contractor
Receiving a bid from a contractor does not guarantee that the work will be completed on time, within budget, or at all.
The founder and CEO of CFSI Loan Management, a national company that mitigates construction risk, stated, “The guy doesn’t have to finish it.” “The originator has a half-built house, and he can leave the job if it’s not profitable. There is a great chance of losing in every situation.
Midway through the project, you might have to fire the contractor you hired if they prove to be unreliable. Timing and budgeting may also suffer as a result of this.
4. Research the contractor thoroughly
You should have questions for a contractor you are hiring. Does the contractor have a license? Do they lack insurance? Do they have enough experience to see that the projected budget is significantly off? It is advisable to allocate additional time to converse with the suppliers and tradespeople of the contractor. This will probably reveal to you how well-established their partnerships are and how well they communicate.
For example, a contractor might have received payment, but there might be problems paying their subcontractor, who may still be entitled to a lien. According to Mingham, “people skip (lien release) paperwork all over the country because they believe their contractor wouldn’t do that to them or that they don’t need it.” “But things do occur.”
Do you want to better manage the risk of your construction loans? Make sure you investigate the contractor thoroughly.
5. Try not to rely too much on technology
It is advisable to steer clear of over-reliance on technology, particularly in the context of budgets and inspections.
Technology is unable to determine whether a budget for a high-rise condominium in Des Moines is accurate in comparison to one in New York City, according to Mingham. It only understands that there are prices; it has no idea whether they are appropriate. It is unaware that certain details are lacking. Experience captures that; technology does not.
For example, CFSI collaborates with lenders during the underwriting process to identify projects that are realistic. On the back end, they assist with budget management, scheduling inspections, and gathering paperwork for multifamily, commercial, and residential projects.
Mingham stated, “Risk management is it.” “We go out and physically inspect the property, and we certify to the person that all of their requests have been fulfilled, the permits have been approved, and we have obtained all lien releases.” That’s risk management in construction.
Final thoughts on construction loan risk management
It’s critical to comprehend the various project risks prior to obtaining a construction loan. Effective risk management for construction loans not only reduces the risks associated with planning and budgeting. Additionally, you assess the potential effects of these risks and put policies in place to lessen their financial impact on the company.
Recall that enhancing your construction loan risk management requires you to conduct thorough due diligence on the part of the lender, contractor, and construction experts.
