Construction lending carries risks for financial institutions beyond the usual risks of most types of loans. Instead of issuing a loan against known assets or strictly on financial means and history, a construction loan is taken out against an asset that doesn’t exist yet, and that will be constructed under real-world conditions that often don’t match the plans drawn up on paper.
For this reason, a construction contract review is a critical due diligence tool as part of a Plan and Cost Review (PCR). The construction contract review helps protect lenders against common mistakes that can be extremely costly for the lender and their client.
At GLE, we review hundreds of construction contracts for lenders every year. Every year, the same mistakes appear in contracts over and over. Here are five that can quickly sink your investment.
1. The Construction Contract Does Not Provide for Owner Retainage
Owner retainage refers to a percentage of contractor’s payments that are held by the owner until certain milestones are met by the contractor. This construction contract provision helps to ensure that contractors complete their work correctly and in a workmanlike manner.
Typically, we suggest that owners hold 10% until the project is 50% complete, and then 5% until the project is complete and signed off. Yet surprisingly often, we often see contracts with no retainage specified at all, which creates unwarranted risk for the borrower and the lender alike.
2. Payment Terms are Too Generous or Too Restrictive
Payment term problems are the most common construction contract mistake we see. Often, the terms pay out too early and fast, or they hold funds too long.
Typically, it’s in the owner’s best interest to pay slowly, while it’s in the contractor’s best interest to be paid quickly. Either way can get the project into hot water. When funds are required to the contractor too quickly, there is not enough time for the lender to complete all of the due diligence and administrative activities necessary to safely fund the draw. This can wind up putting owners into default for being unable to pay on time.
On the other hand, if the contractor isn’t paid in a timely manner, it can delay work as materials and subcontractors rely on timely payments to continue the work.
Generally, an appropriate payment term schedule is twenty to thirty days.
3. Contractor Not Required to Carry Appropriate Bonding and Insurance
Bonding should be a standard element of a contract, but sometimes it’s not. Without a performance bond, a contractor may simply walk off the job, leaving the owner scrambling to complete the project.
Likewise, a payment bond should be provided, ensuring that all subcontractors and material suppliers are paid, even if the contractor neglects to do so. The construction contract also should specify insurance coverages that clearly defines adequate limits to cover the project in the event of problems. These coverage limits should always be spelled out in the contract. Too often, they’re not, and this leaves owners and lenders in a risky position.
4. No Liquidated Damages Specified
A liquidated damages clause protects the owner and the lender in the event that the contractor does not complete the project on time. This construction contract provision requires the contractor to pay the owner a set amount per day for every day past the date that the contractor has agreed to complete the project.
This is an incentive for the contractor to finish on time, as well as a financial buffer for the owner, ensuring that they are able to recognize anticipated revenue while the building continues to sit unfinished. When liquidated damages are not specified, a delay in the construction timeline can lead to substantial financial losses for the owner, and in turn creates financial risk for the lender.
5. Using Non-Industry-Standard Contract
The American Institute of Architects has established standard owner/contractor agreements that are valid for most projects, but some owners and builders still choose to create a custom contract. These custom contracts lack the court- and time-tested language of a standard contract, and can contain many unexpected pitfalls for owners and lenders.
While a non-industry-standard contract may be appropriate in some cases, these should always be carefully reviewed by an expert. Even then, the terms as you understand them may not hold up in court. It is almost always in the lender’s and borrower’s best interests to use an industry-standard construction contract.
We recommend that lenders always insist on a Plan and Cost Review (PCR) that includes a construction contract review prior to lending against construction projects. A complete PCR also includes a review of the construction drawings, which you can find out more about here.
GLE provides comprehensive construction loan and consulting services to help you manage your lending risks. Call us today.
