Robert Szustakowski, The Lotis Engineering Group, PC

Construction loans are significantly different from other real estate loans. On a typical commercial real estate loan, the bank relies on the appraisal and an appropriate loan-to-value calculation. While an appraisal is obtained with the “upon completion” value for a construction loan, it is possible that the final value is significantly more or less than the cost of construction and land acquisition. If the construction cost exceeds final value, the project is immediately upside down. Alternatively, the lender should not put more into the project during construction than is actually spent.

A good construction loan requires some very clear answers to the following questions.

  • Can you construct the project as designed or is there some sort of underlying flaw?
  • Are the cost estimates prepared by the general contractor (GC) accurate based on experience of your construction consultant?
  • During construction, are the plans being followed?
  • Is the construction on budget and on schedule?
  • Is there enough money in the budget to complete the project?

Unfortunately, unlike Property Condition Assessments (PCAs) or environmental assessments, there are no ASTM or similarly recognized standards for consultant’s products used by banks in construction lending. Further, due to the technical nature of the required documents, you need to put significantly more reliance on the ability of your consultant; especially if your Relationship Manager’s (RM’s) construction experience is limited.

The purpose of this document is to provide some guidance on what to look for, what to ask for and point out some “red flags” before and during the construction process. Note that this explains the use of construction consultants; it does not discuss other requirements for disbursement that may be required by the bank.

Plan and Cost Reviews

The Plan and Cost Review (PCR) or Plan, Specification and Cost Review (PSCR) is the first step in review of a construction project. This is the step that tells you “Can I complete this project for the money suggested?” and is likely the most important step. It is also the most difficult for the less experienced borrowers and RMs to fully review and understand.

For the construction consultant to complete this step correctly and completely, they need a wide range of documents that vary based on the complexity of the project. Commonly required documents include the following.

  • Demolition Plans
  • Civil/Site Plans
  • Architectural Plans
  • Mechanical, Electrical and Plumbing Plans
  • Fire Protection Plans
  • Project Specifications
  • Geotechnical/Soils Report
  • Contractor and Architect Contracts
  • Contractor and Architect Qualifications and Licenses
  • Bonding and Insurance for Contractor
  • Building Permits
  • Code Compliance Documents
  • Utility sign-offs
  • Detailed breakdown of construction costs
  • Development budget

In reality, the construction consultant will not be provided complete and final versions of all of these documents at the beginning of the project. They are typically not at that stage when the review process must begin. And the smaller the project, the fewer documents available. I’ve seen small renovation projects where only GC-prepared documents are a two-page proposal. This makes it extremely difficult for the consultant to make any relevant conclusions.

The consultant must assess what are the “have to haves” versus the “nice to haves” based on the scope and complexity of each project. Each consultant has a different opinion on this. The consultant should state in their PCR report any limitations caused by missing or incomplete documents. Such limitations should also be evidenced by the proposed budget contingencies; that is, more uncertainty should result in higher contingencies.

There are no standards for a PCR report; as such, the consultant’s written PCR report to the bank should be in a form acceptable to the bank. While this varies significantly bank to bank, a two-page summary for multi-million dollar construction project should not be considered acceptable, although experience suggests that some lenders have accepted such minimal documentation.

A more complete report should include the following.

  • List of documents reviewed, including authors and dates
  • Completeness of documents reviewed (e.g., 75%; 90%, etc.)
  • List of missing or incomplete documents based on what the consultant feels should have been reviewed
  • General comments on quality of documents
  • Detailed description of the project, from demolition to completion, to assist in the review of their PCR
  • Reasonableness of construction methods, plans (if the plans include driving piles, is it even possible to drive piles or do they have to be drilled?)
  • List of all parties involved along with any relationships between parties (some lenders do not allow the borrower to be related to the GC)
  • Qualifications of and experience with parties involved
  • Discussion of schedule and if it appears reasonable
  • Nature of architect and contractor contracts
  • Budget breakdown analysis, including on a square foot basis
  • Comparative cost analysis (GC’s budget versus the consultant’s anticipated budget)
  • Budget contingency recommendations

The main takeaways from the report by the bank should include the following.

  • Can the project be completed as planned? This is often overlooked by the consultants. The consultant may tell you that the budget and plans are appropriate for a slab-on-grade construction without commenting on the fact that the soils will not support the structure without driving piles, which was not included in the budget. So, it is important for the consultant to comment on whether the entire plan is reasonable. They may also make recommendations for less expensive construction techniques.
  • Can the schedule be met? Time is money and commitments expire. Is the schedule reasonable, especially for predictable but uncontrollable events, such as winter weather as well as municipal and utility delays? A need to pave parking lots in February in the Northeast may not be reasonable. What will be the impact of such delays?
  • Are the parties qualified? Do the architect and general contractor have relevant experience? Use of a home builder to construct a high-rise would not be appropriate regardless of the strength of your borrower.

Is the budget appropriate? Banks fund construction projects by line-item, not total budgets, so the budget review must include a line-by-line review of the budget. Each line item should include the consultant’s estimate for that same effort along with the source of that estimate (e.g., published records, past experience, etc.) Even if the total budget is spot-on, any single line items that vary by more than 5% to 10% need to be discussed in detail. It may be necessary to modify the project budget to be consistent with your consultant’s opinion. Otherwise, you may need to use the contingency budget on a line item you already knew was not properly budgeted.

What should the contingency be? The bank may have required or recommended contingencies but the consultant should provide suggestions as well. This should be for unanticipated expenses only. For example, if a project takes longer than expected and costs increase due to winter work, use of the contingency may be necessary. But if it was known that the project would extend into the winter, those additional costs should be in the line item, not funded by the contingency. The contingency should also take into account the completeness of the documents reviewed. If only a skeleton of the required documents was provided, a higher contingency would seem appropriate.

A final note. If there is significant time between the PCR/PSCR and the funding, it may be necessary to have the costs re-reviewed by the construction consultant prior to closing and/or funding. The cost of construction materials may vary significantly due to changes in oil prices, changes in the economy, natural disasters and other unforeseen events. Your construction consultant can likely assist you in determining if a new review is warranted.

So, What’s The Budget?

At this point, you have at least two, and likely more, proposed budgets for your transaction. You have the original budget requested by the borrower, likely included in your preliminary approval documents. You have the budget provided in the plans and specifications. You have the budget provided by your construction review consultant in the PCR. Which do you use?
Typically, the budget completed by your consultant should be the most “correct.” It was prepared on your behalf by a firm that you (assumedly) have faith in to complete the review. But there may be reasons to modify that budget, so as to add or subtract funds for small project changes, a contingency modification, etc.

Regardless of what budget you use, be sure to provide the final budget to your consultant doing the Construction Inspections (below). This will assure that all of you are on the same page.

But be prepared for the consultant to disavow responsibility for line item costs inconsistent with his/her recommendations. [The “I told you so” effect.]

Most banks require a retainer from each GC request for draw. The retainer, typically 5% to 10%, may be governed by state law. It is intended to assure that the GC will successfully complete the project. Some banks allow retainers to decrease as a project nears completion. All of this is up to the bank but must be communicated to the consultant.

Construction Inspections

The Construction Inspections are completed to document that the project is proceeding as planned and make recommendations for payments to the borrower/GC, if appropriate. A few things to keep in mind for Construction Inspections.

  • It is typically recommended that the firm that completes the PCR/PSCR complete the Construction Inspections. That firm is most familiar with the project and concurred with the construction costs and schedule. If you contract a different firm, expect that firm to request funds to review the PCR/PSCR and to disavow responsibility for line items that were not properly budgeted as they were not involved in the budgeting step.
  • Construction Inspections should start at the very start of the construction, even if there are no funds to be released by the bank yet. If you use the inspections as solely “draw” inspections, you may have millions of dollars spent by the borrower before your consultant even sees the construction. The consultant cannot comment on the quality of the construction if it was not observed and the possibility exists for a budget to already be off by the time of the first inspection for a draw. Further, the regulators require that the borrower provide his/her cash into the project before the bank and this provides a simple way to prove that.
  • The construction consultant should be provided all documents presented by the GC to the borrower for payment associated with that inspection; all payment requests should have already been approved by the GC, the borrower and his/her architect. The consultant may need to request additional background information, especially if one or more items appear inappropriate. The consultant should be instructed how to handle deposits and stored materials, as each lender handles these items differently.
  • The Construction Inspection report should include a line-by-line listing for all work completed, including percentage complete and funds expended to-date. There should also be a total of percentage complete and funds expended to date. The percent complete should NOT be based on funds expended to date but the consultant’s estimate of progress. They are often not the same but many consultants assume that they are.
  • For draws, the consultant should provide a recommended amount to fund; again, this may be inconsistent from that requested by the GC. Line items that appear to be out-of-budget, either over- or under-budget, need to be discussed separately. It may be necessary to increase a budget line (either through use of contingency or otherwise) or it may be possible to free up funds from another line. These are not decisions to be made by your consultant but by the bank but later communicated to the consultant.
  • Every construction inspection report should include two important items: are we on schedule and do we have enough money left to complete the project? These two statements should be clear on each report.

Based on the consultant’s recommendations, the bank decides what to fund on a project. However, it is important for the bank’s consultant to be notified of the final funding decision for line item for each draw if inconsistent with the consultant’s recommendations. Otherwise, the consultant and the bank will be working off different budgets creating confusion in further draw requests.

Final Inspection Reports

At the end of each project, the consultant should complete a final “upon completion” inspection report; this should be after the Certificate of Occupancy is provided by the municipality. At that time, the retention would typically be released.

About the Author

Bob has been completing environmental due diligence for lenders for 30 years. He has developed and managed environmental programs, as a consultant and bank employee, for some of the largest and smallest banks in the country. He has also devised bank programs for construction monitoring and routine property inspections.