IrvineMarket

A bank's commercial construction lending activities can encompass a wide variety of projects ranging from apartment, condominium, and office buildings, to shopping centers and hotels. Each type of project requires a developer with special skills and expertise to successfully construct, manage, and market the project.

Commercial construction loan agreements sometimes require the borrower to have a pre-committed, permanent loan to take-out the construction lender. Such commitments, however, are usually written in a way that the permanent lender can rescind its commitment to fund the permanent loan if there are any problems with the project. A number of banks have been forced to convert their construction loans to mini-perm financing because a development project became troubled and either lost, or was unable to attract, a permanent lender.

A bank may enter into an "open-end" construction loan in which there is no pre-committed source of repayment. Openended construction loans entail additional risk because a bank making such a loan may be forced to provide permanent financing to the borrower, oftentimes in distressed circumstances. When evaluating the risk posed by an open-end construction loan, a bank should consider whether the completed project will be able to attract extended-term financing that can be supported by the projected net operating income from the project. Some construction lenders use a "mortgagability" analysis in assessing the risk of an open-end construction loan. Under such an analysis, the lender uses the net operating income expected to be generated from the property when completed in determining how large an amortizing, permanent loan the property could support.

A bank should review the feasibility study for proposed construction projects, including any sensitivity and risk analyses. Such studies usually include a marketing plan for the project and information about the project's anticipated absorption rate based on estimates of future supply and demand conditions. A feasibility study is especially important when a bank is considering an open-end construction loan because repayment of the loan may depend upon the project's sales or leasing program.

One way for a bank to minimize commercial construction lending risk is to fund the construction loan after or at the same time that the developer's equity contributions have been provided. Such "stage-funding" agreements allow a bank to disburse loan funds to coincide with equity contributions at agreed-upon-intervals during the construction, marketing, and management phases of the project.

Stage funding agreements are common in syndicated commercial real estate projects. Syndicated arrangements often permit the developer to receive equity contributions from investors throughout the life of the project. If the project relies upon a syndication of investors, the bank should assess the likelihood that the syndication will be able to raise the necessary equity.