by Phil Love
President/CEO Pactola

Many a lender who has experience with residential construction has been tripped up once they are overseeing a commercial project. My first commercial project was a multi-tenant medical office building in my hometown. Luckily, I had a seasoned credit manager who could help me look at the right things in managing the project.

Commercial construction differs from residential in several areas. In commercial we will use the draw process to track both the loan funds and the borrower’s equity contribution into the project. Commercial construction works off a project budget that includes items like monthly interest expense, closing costs, and other soft costs as part of the overall project budget. These items are not typically calculated in the residential construction process. 

Residential building loans are dominated by a percent of completion method. In commercial, this may be a bit skewed at times with the need for stored materials in the project. One example here is a hotel where up to half of the cost of FF&E will be required to be paid when the furniture is ordered. This may result in the loan being out of sorts with the actual percent of completion at that time, but it is necessary to have the beds, chairs, and other furniture in place when the hotel opens. 

Any construction project has the risk of the project being completed on time, on budget, and according to plan. If you have overseen construction lending for any period, you have experienced projects that went off the rails on at least one and possibly all three of these circumstances. The protection for the lender here lies with the sponsor’s resources and contractor’s execution of the project.

Commercial draws may be reduced by retainage that is pulled out of every draw to keep the general contractor motivated to get the project completed. Often this is paid out once items on a final punch list are completed. These projects may also be large enough to require a payment, performance, or surety bond. Another option is to have a standby letter of credit posted by the general contractor. Any of these items may help mitigate the risk of the contractor finishing the project. 

Most construction projects also require a professional third-party inspection. I rode along with the first inspection on my medical building and learned quickly that these are best viewed by a professional. My house construction training proved of little use in this case. The inspector, who had over 30 years of construction experience, taught me that it is often best to have the budget reviewed by a qualified third party, something that is not usually done when building a house. 

The risks in commercial construction require a dive into the financial condition and building expertise of the builder. Some institutions keep a list of contractors that are preferred or ones to avoid. While we do not want to cross over into any lender liability, we do understand that a new contractor not on our positive experience list will require more scrutiny. There may also be some extreme cases when the loan request will be denied because of an utter lack of faith in the contractor coupled with a lack of abundant resources of the sponsors to pay the extra cost.

When looking at the resume and book of business with the contractor, start with their website for other projects. If any are in your area, take a field trip. Get a copy of their licenses and a list of customer, bank, and supplier references to check. In some cases, you will want the general to provide financial statements and proof of their lending line. A quick LexisNexis search can show any former or current lawsuits. I once had a loan request we turned down because the general contractor had a criminal record for bank fraud!

One tool to use is the Fannie Mae Form 1202 Contractor Profile Report. This is a one-page form for the contractor to complete that outlines their experience and references. The form can be valuable for your borrowers to use as they review the prices and experience of various contractors. The review of this is also a great tool for your loan file. If you have a more complex project, consider five-page American Institute of Architects Form 305 Contractor’s Qualification Statement. This form goes into more detail and should be required on larger and more complex projects. If the contractor is not willing to complete these, consider going to another contractor. Any seasoned and experienced contactor will be used to providing this information for customers and their lenders.

Quick Bites:  The current interest rate curve is flattening. This happens when the difference in yields from the short to long term rates is narrow. Some are beginning to get nervous as every time the yield curve has inverted (where short-term rates are higher than long-term ones) since 1970, has signaled a recession.

The economy shows very little other signs of an upcoming downturn. In fact, the economy is doing so well the Fed is more concerned with inflation and a tightening labor market and has been, and will continue to increase short term rates this year. Longer-term rates have not increased as much yet as population and labor productivity increases are weak. Lenders tend to also be late to the game in recognizing these factors and changing their rate accordingly.

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You can contact Phil at or 605.223.5154.



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