FEATURE ARTICLE, APRIL 2007

BUILDING ON A SOLID FINANCIAL FOUNDATION
Bracewell & Giuliani LLP provides insight into the basics of construction loans.
Alfred Kyle

In boom times and in bust, the competition for real estate project financing is always intense. During periods of economic growth, the number of developers seeking financing rises quickly; in a downturn, lenders are more selective about the loans they will approve.

This competition is further intensified in Texas, where the local concentration of bellwether industries — including energy, technology, finance and air travel — is especially sensitive to national economic trends. The recent, positive growth in commercial and office projects, especially in the state’s larger cities, means that more developers are competing for the available construction-financing resources.

It’s a simple rule: If a developer can’t get appropriate financing, the project won’t get built. Before you put mortar to brick, you must get your construction-financing house in order. This article will review some of the primary objectives of construction financing, describe the risks and remedies available to borrowers and lenders, outline the typical steps in obtaining a loan agreement, and suggest ways that outside legal counsel can help smooth the process.

Construction Financing: Who Needs It?

Generally, construction financing is sought for three main purposes: the purchase of land; the development and construction of improvements on the land; and the operation and management of specific projects (comprised of the land, buildings and facilities that have been leased). Successful borrowers are able to move forward on the project and toward ongoing business objectives without tying up a significant portion of their own assets.

Construction lenders are also seeking to invest in projects that have a likelihood of providing a favorable return. Lenders typically underwrite projects through short-term credit facilities with a duration (“maturity”) of 12 to 36 months. During this time, owners and developers can move forward with construction.

Loans are often structured as advancing term loans; that is, borrowers are given monthly advances or draws, the delivery of which ends before the loan matures. Construction lenders typically withhold up to 10 percent of each draw to insure payment of contractors. In Texas, project owners are required by statute to retain 10 percent of either the contract amount or the value of the work done, or become personally liable for the amount not retained.

Loan amounts typically total approximately 50 to 85 percent of the appraised value of the completed project, or 70 to 100 percent of the total cost of the project as evidenced in an approved construction budget. In each case, the applicable value must be clearly documented and the basis for the estimates demonstrated. For the appraised value, lenders are required by federal regulations to obtain an independent appraisal of the project’s expected value upon completion.

Borrowers should also be aware that lending institutions (at least, those that maintain federally insured deposits) must adhere to certain limitations on the maximum amount of the loan, as a percentage of projected value. Known as “supervisory loan-to-value limits,” exceeding these ratios automatically initiates various reporting and other requirements that lenders typically prefer to avoid. In Texas, where property values tend to fluctuate more than the national norm, this means that lenders must pay close attention to these limits. This may also reduce the availability of capital to borrowers.

Although most construction loans mature in 1 to 3 years, under certain circumstances borrowers may obtain one or two extensions in periods of 6 or 12 months. However, the principal borrowed will also begin to amortize during this period, usually on a 25- or 30-year schedule.

What Are The Risks?

As with all business decisions, construction loans are not without certain risks. These risks and typical remedies include:

Failure to complete construction and/or insufficient funds to complete construction. Lenders often ask borrowers for completion guarantees or performance bonds. Obtained by the borrower from a commercial surety or bonding company, these provide a third party to which the lender can turn, to ensure completion of the project and to cover any excess costs of completion.

Failure to pay materialmen. Lenders also seek protection against the possibility that borrowers will not pay subcontractors. One method of mitigating this risk is for lenders to write a provision into the loan documents that allows them to pay subcontractors directly from the proceeds of the loan. Payment bonds also may be required of borrowers; similar to performance bonds, they provide assurance that mechanics and materialmen will be paid. The Texas Property Code sets out specific requirements for payment bonds. If owners comply with these requirements, the owners as well as the property is protected from lawsuits by claimants. Other options for ensuring payment to subcontractors include borrower’s deposits and lien waivers.

Inability to lease space. Lenders condition the funding of loans and delivery of advances to the percentage of executed leases during the construction project. In other cases, debt service coverage tests are used to condition funding upon certain levels of net operating income — if the project is not performing, funding is delayed.

Inadequate source of repayment. To minimize risks to final repayment of the loan, construction lenders may require commitments from permanent lenders. These include forward loan commitments (which commit the permanent lender to a future loan, subject to certain conditions); buy-sell agreements (in which the construction lender agrees to sell the permanent lender all rights and title to its loan); and extension options (which are incorporated into the original loan documentation and may include long-term extensions, or “conversions”).

Loan Agreement Documentation

Second only to negotiation of the terms of a construction loan is the documentation of the loan. The actual construction loan agreement is the basis for all future activities, once the deal has closed. The agreement spells out what actions must be carried out, the schedule of these activities, the conditions under which the activities must occur or can be modified, and the specific dollar amounts in question. It is incumbent upon borrowers and their legal counsel to understand every aspect of the construction loan agreement to prevent unpleasant surprises.

Most construction lenders have their own set of internal guidelines regarding commercial construction loan applications, approvals and documentation. However, these policies are not enforceable by law against a borrower unless they have been specifically incorporated into the loan documentation. This ensures that both parties are fully aware of the terms of, and remedies available, under the agreement and applicable statutes.

Many lenders supply their own forms that attorneys and borrowers must use for each transaction. Once again, lenders — especially those that operate on a national level — may not be aware of specific local and Texas laws that apply to construction lending within the state. An effective attorney will work with the lending institution and its personnel in order to ensure that the final documentation incorporates the lender’s internal policies as well as applicable statutes in the local jurisdiction.

Outside Counsel: Smoothing The Process

Whether acting on behalf of borrowers or lenders, outside legal counsel can play a critical role in streamlining the negotiation, documentation and closing of construction loans. As the primary drafter of the loan documents, the attorney is responsible for accurately transcribing the client’s objectives and intentions into a legally enforceable agreement. This due diligence includes the creation of all supporting documentation, including checklists, term sheets, disbursement schedules and procedures, guarantees and protections and assignment of rights.

Further, while outside counsel should have complete familiarity with all federal regulations and guidelines that bear on construction loans, lenders and borrowers planning projects within the state of Texas should seek lawyers with a solid knowledge of state and local statutes. By involving such an attorney throughout the process, all parties can ensure that the construction loan agreement not only reflects their objectives and balances risks with opportunities, but will also stand up to potential challenges.

Think of it this way: You would not build your office, store, apartment complex or factory with poor materials and shoddy workmanship. Should you take any less care with the financing of your project?

Alfred Kyle is a partner at the Dallas office of Bracewell & Giuliani.


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