Construction Loans A Risky Business

February 14, 2005
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GRAND RAPIDS — A bank can choose to finance any one or all phases of a commercial construction project, but it has to choose carefully because construction loans are vulnerable to a wide variety of risks.

In residential lending, a person buys a house, closes the loan on it and the loan is sold to the secondary market rather than being housed at the originating bank.

But in commercial lending, there is no standardization among borrowers and no secondary market to which to sell those loans, said Mark Augustyn, senior vice president of Mercantile Bank of West Michigan.

In general, the risks include taking on a budget in both dollars and time, he said. He said one big question in lenders' minds is whether the borrower can make up the shortfall if the project was expected to cost a half million dollars and ends up costing several hundred thousand more.

Project timelines are important, too, so the lender keeps tabs on them. Mercantile, for instance, monitors a project by sending personnel to the construction site with a digital camera to document its progress in stages.

On a construction project, Augustyn explained, the borrower typically tends to draw on the loan once a month, so the monitoring system assures the bank that each disbursement actually covers work completed to date. 

"If the project takes too long — and it's a property that you want on the market in the spring and don't make it — then you're missing your building window or retail window and the project takes on a different element," he said.

"Now you have the added risk of subcontractors that may not be paid and they can file liens on a job."

If the borrower is a developer that's just employing a contractor to build a property, then the lender would look exclusively at the borrower's capacity to carry the project, he said.

If the developer is also the owner of the building, then the lender evaluates the reputation of both the developer and contractor and, perhaps, that of the capital partners they're bringing into the development group.

Overall, Augustyn said two of the most important considerations are the capital the developer brings to the table and the credibility of the contractor he's using.   

The lender also has to get a good handle on what other developments the borrower may have going on. If the borrower has several projects that are performing poorly, which could affect his company's financial outlook in the next three to five years, it could potentially hurt the project being proposed, he explained.

In his estimation, the local market has a "very big stable" of notable, reputable, honest contractors who can build a building and do it reasonably on time and at cost.

"If you look at the Top 10 list of contractors or developers in town, we probably have a relationship with the majority of them. These folks have the expertise to do what they do. They've spent years building a reputation and they're not going to ruin it for one particular project.

"A fair amount of the ones we work with have quite a long history and track record of successful projects, which, obviously, builds confidence in the next one and also lends support to the newer ones they're taking on." 

He said Mercantile's commercial borrowers are typically folks the bank has worked with for quite some time or that have been referred by people the bank has worked with for a long time, lending instant legitimacy to both the project and the people involved.

"We try to focus here on lending to people, not to projects," he said. "We try to get to know the people well that we're lending to. The projects are certainly important, but the best people tend to find the best projects."  

Like many banks in the local market, when Mercantile books a loan, it keeps the loan.

"We'll book the loan from land acquisition and construction through the finished product and then retain the loan throughout the history of the loan. That's why we take a lot of time on the front end to understand what we're getting into."

In some markets, when a commercial project is completed and ready to start generating income or be sold, it's refinanced by longer-term institutional lenders and investors, such as an insurance company, pension fund or REIT. 

In Augustyn's 15 years of experience in commercial lending in the local market, very few projects end up in insurance companies' hands — and for a number of reasons.

"They're fairly inflexible in how they can structure things, they have sizable prepayment penalties and anytime you have to renegotiate anything, they look at it new every time.

"The bigger the deal, the more national the tenant; certainly some of those have insurance company appeal — a very long lease with a national tenant with a sizable transaction.

"But the buildings you see around here — the 10,000-square-foot, four-tenant buildings — I would say 99 percent of those are financed through banks."

Mercantile is currently financing more than 20 commercial projects in greater downtown Grand Rapids. Augustyn said the bank typically finances about 80 percent of a commercial project, though it can vary one way or the other from project to project.

How much a borrower can borrow and at what rate are the hardest two questions to answer at the outset, he noted.

"You really have to analyze the whole pie that they're working in and how to structure the loan."    

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