A Bank must monitor the progress of the project to ensure that the borrower’s request for funds is appropriate for the particular stage of development and in accordance with the predetermined Disbursement Plan. The Bank must obtain accurate and timely inspection reports reflecting the status of the project and alerting it to situations where the project is not proceeding as planned.
To detect signs of financial problems in a project or with the developer, a Bank periodically should review the developer’s financial statements and accounts receivable and payable. The Bank should review the statements to assess the liquidity, debt capacity, and cash flow of the developer. The review can help detect problems not only with the Bank’s own loan, but also potential funding problems arising from one of the developer’s other projects. The Bank also should review the borrower’s major sources of cash, and ascertain whether the source is dependent upon the sale of real estate, expected infusion of outside capital, or income generated from completed projects.
Other ways to detect problems include obtaining an updated credit report on the developer to determine if there are any unpaid bills, if trade payables are being paid late, or if suits or judgments have been entered against the borrower. In many localities, banks may also access weekly legal reports and trade reports to investigate the borrower’s standing. A Bank should also verify ad valorem and other tax payments to ensure that the borrower is making timely payment.
Most construction budgets include an amount that is allocated for contingencies. These amounts are intended to cover reasonable but unexpected increases in construction costs. They are typically used to cover such things as price increases in materials, or the need to pay overtime because of delays in the shipment of materials or adverse weather. Cost overruns on a project, however, may also be the result of poor job estimating. In that case, the increased cost should ordinarily be covered by the borrower rather than by a draw-down on the loan amount budgeted for contingencies.
The construction lender should also be wary of funds being misused to pay for extra costs not stipulated in the loan agreement. Examples of extra costs include rebuilding to meet specification changes not previously disclosed, starting a new project, or paying subcontractors for work performed elsewhere. The practice of “front loading,” whereby a builder deliberately overstates the cost of the work to be completed in the early stages of construction, is not uncommon. If the Bank does not detect this problem in the early stages of construction, there will almost certainly be insufficient loan funds to complete construction if there is a default.
An established loan administration process that continually monitors each project’s progress, costs, and loan advances is essential if a Bank is to effectively control its commercial construction loan program. A Bank must periodically schedule physical inspections of the project and evaluate the work performed against project design and budgeted cost. Banks will often retain an independent construction consulting firm if they do not have the necessary in-house engineering, architectural, and construction expertise to perform this function.
A Bank should obtain monthly reports of work completed, cost-to-date, cost-to-complete, construction deadlines, and loan funds remaining. Any changes in construction plans should be reviewed by the construction consulting firm and approved and documented by the Bank and take-out lender. A significant number of change orders could indicate poor planning or project design, or problems in construction, and should be tracked and reflected in the project’s budget.
A Bank must also monitor general economic factors that could affect the success of the project upon completion. Since the development, construction, and lease-up of a commercial project can span several years, the Bank must continually assess the marketability of the project and whether demand will continue to exist for the project when it is completed.