Introduction
This article is a sequel to “The Blind Spot” (see link) that sets the stage for why “operational risk” matters to construction or renovation lending. We will start by showing visually why the draw management process can be one of your most important defenses to the operational risks in construction lending. Then we examine some best practices and their related caveats for draw management.
Illustrative example: Expected property value during a renovation
Unfortunately, expected property value does not rise “up and to the right” only during a renovation. There is a danger zone where expected property value dips for some/most projects, typically from demolition through rough construction completion. Makes sense intuitively as the renovation involves destroying the collateral in part to rebuild back better (hopefully).
Beyond an implied instability in the loan-to-value ratio, there is a higher associated cost of taking back an incomplete property during that phase. Furthermore, projects at any time may face unforeseen circumstances ranging from unexpected requirements (e.g., retaining wall, sewer main repair) to events like extreme weather damage.Loan-to-value is a dynamic concept in construction lending.
Ensuring construction holdback capital is deployed proportionately to project completion is a key mitigant and the responsibility of the draw manager in battling your operational risks.
Beyond an implied instability in the loan-to-value ratio, there is a higher associated cost of taking back an incomplete property during that phase. Furthermore, projects at any time may face unforeseen circumstances ranging from unexpected requirements (e.g., retaining wall, sewer main repair) to events like extreme weather damage.Loan-to-value is a dynamic concept in construction lending.
Ensuring construction holdback capital is deployed proportionately to project completion is a key mitigant and the responsibility of the draw manager in battling your operational risks.
So what is “draw management”?
Funds paid at closing are generally used for acquiring the “as-is” property while the remainder is retained in a “holdback” that is held back (true to its name) for use during construction, enabling the transformation of the property to its highest-and-best use or “after-repair value” (ARV).
Holdback funds are released from the total loan commitment as the project progresses via draw requests by the borrower which are approved by the lender.
In effect, every draw in a construction loan is a mini underwrite - not of the Sponsor, but of the loan’s current state vis-a-vis the underlying property’s unique path to completion.
Holdback funds are released from the total loan commitment as the project progresses via draw requests by the borrower which are approved by the lender.
In effect, every draw in a construction loan is a mini underwrite - not of the Sponsor, but of the loan’s current state vis-a-vis the underlying property’s unique path to completion.
The fundamentals of draw construction management
#1: Work in place before money out
The “work in place” standard is a basic tenet in renovation and construction lending. Work in place refers to measuring the project’s hard cost completion in terms of completed labor and materials that are physically installed onsite (i.e., “in place”).
As a rule of thumb, holdback releases should align proportionally with project completion. Measuring hard cost completion involves inspections of progress (ie, draw inspections). Inspections require detailed project context and expertise. Inspectors may perform their work onsite or remotely, and potentially facilitated by technology enabling borrowers to submit photo or video evidence of progress.
Consistent inspections and informed draw reviews enable lenders to identify potential issues early, mitigating risks before they threaten the project's long-term viability. To maximize operational risk mitigation, inspections should…
As a rule of thumb, holdback releases should align proportionally with project completion. Measuring hard cost completion involves inspections of progress (ie, draw inspections). Inspections require detailed project context and expertise. Inspectors may perform their work onsite or remotely, and potentially facilitated by technology enabling borrowers to submit photo or video evidence of progress.
Consistent inspections and informed draw reviews enable lenders to identify potential issues early, mitigating risks before they threaten the project's long-term viability. To maximize operational risk mitigation, inspections should…
Require a qualified inspector who knows the project’s current scope, budget, and the starting state as a baseline. Sharing the appraisal with the inspector is a best practice, so they can reference photos of the property's starting condition and the description of scope. No inspector or inspection is perfect of course, the goal is a reasonably informed opinion done in a reliable and systematic manner.
Ensure an independent judgment that minimizes misalignment in the determination of completion. Sometimes inspectors can become too cozy with a borrower, and in extreme cases even outright collusion has occurred. Lenders with in-house inspectors ideally separate that role from borrower relationship manager to avoid undue influence.
Avoid blurring lines of inspector recommended vs lender approval so you are aware of significant variances in how your draws are approved compared to project completion rate. Growing variances can mean holdback funds are being released ahead of sufficient completion and may expose you to significant operational risk if you had to take back the property.
Further, watch for completion numbers in inspection reports being “adjusted”, as this may be warranted but should be documented and monitored to ensure approvals are achieving risk mitigation.
Further, watch for completion numbers in inspection reports being “adjusted”, as this may be warranted but should be documented and monitored to ensure approvals are achieving risk mitigation.
Monitor for errors or fraud, especially if allowing borrowers to submit their own photos or videos. Known fraud risks include photos taken at a different unit or job site or photos taken of photos. Inspectors are also human and can simply make mistakes, including not noticing things or more egregious errors like inspecting the wrong location (or even tricked into doing so).
Now there are two notable exceptions to this work in place standard…One common exception is soft costs (e.g., architect fees, permitting costs). While no observable progress is made, soft costs are part of every project and necessary to complete a project. However, most lenders allow draws to include soft costs but release funds only proportionate to the hard cost completion.
Some lenders will release soft costs in full as incurred for repeat borrowers, if in good standing. In either case, approving soft costs causes a rising variance in the lender approval vs hard cost completion, which may be fine but should be monitored. Another common exception is material deposits or offsite storage, which present a unique challenge. In these cases, there is no observable progress in completion, and the materials have not been delivered to the site yet. However, withholding funds for deposits can delay the project if the borrower cannot cover the upfront costs.
As such, some lenders will make a partial allowance for materials deposits, say up to 50% with proof of invoice and payment and then the remainder once proof of invoice, payment, and delivery onsite. Others are more strict and require the delivered materials to be fully installed before the remaining holdback funds are disbursed.
Even releasing funds after delivery is a challenge if trust is low given the borrower could deliver materials like lumber or appliances to one property for the inspection then relocate those materials to another property. Similar to soft costs, this causes a rising variance too. Note “trade deposits” are generally not approved by lenders.
Some lenders will release soft costs in full as incurred for repeat borrowers, if in good standing. In either case, approving soft costs causes a rising variance in the lender approval vs hard cost completion, which may be fine but should be monitored. Another common exception is material deposits or offsite storage, which present a unique challenge. In these cases, there is no observable progress in completion, and the materials have not been delivered to the site yet. However, withholding funds for deposits can delay the project if the borrower cannot cover the upfront costs.
As such, some lenders will make a partial allowance for materials deposits, say up to 50% with proof of invoice and payment and then the remainder once proof of invoice, payment, and delivery onsite. Others are more strict and require the delivered materials to be fully installed before the remaining holdback funds are disbursed.
Even releasing funds after delivery is a challenge if trust is low given the borrower could deliver materials like lumber or appliances to one property for the inspection then relocate those materials to another property. Similar to soft costs, this causes a rising variance too. Note “trade deposits” are generally not approved by lenders.
#2: Be mindful of completed work where related parties may be unpaid
Even if an inspection confirms work was completed, there is residual operating risk if the construction vendor or supplier involved was not paid. This creates the potential for mechanics’ liens to be filed, which could result in the lender being “primed” and losing lien priority on the property to these parties.
Lenders and their borrowers may not know about all vendors or subcontractors working on their project yet are still subject to their mechanic’s liens. Signed lien waivers is one mitigation tool for managing the risk of mechanics liens - conditional progress lien waivers prior to payment and unconditional progress waivers after payment has been made. If the right statutory form is signed by the right party in the right amount, these documents can help mitigate risk from vendors known to the borrower or lender.
Known is a key word however… Requesting proof of payment covering the invoices in a draw request is another mitigation tool. Ensuring funds were in fact disbursed by the borrower or GC is critical, as funds sometimes are withheld for various reasons from exerting leverage over subs to contract disputes. Collecting conditional progress waivers and corresponding proof of payment is a respected approach.Lenders also can use title searches to check for any undisclosed liens or outstanding claims on the property.
This may be done as a stand alone or in conjunction with signed lien waivers. Further, title endorsements can be obtained that provide the added protection of insurance but with added cost and delays to the approval process. Renovation often involves only title searches, whereas new construction likely involves title endorsements and lien waivers (and doubly so for larger budgets and project complexity!).
That said, be sure to tailor any risk mitigation to the situation. Asking for say signed lien waivers from a self performing borrower (i.e., no vendors hired) provides little to no protection since the lien claim filed by borrower against his own loan would be unlikely to hold up in court. Similarly, accepting lien waivers signed by the borrower when there is an independent GC vendor or signed by the GC for their sub’s or supplier’s work does not mitigate lien risk either. Bottom line - Lien waivers used inappropriately are unlikely to provide protection and worse, can damage the customer experience and/or your credibility in the market.
Lenders and their borrowers may not know about all vendors or subcontractors working on their project yet are still subject to their mechanic’s liens. Signed lien waivers is one mitigation tool for managing the risk of mechanics liens - conditional progress lien waivers prior to payment and unconditional progress waivers after payment has been made. If the right statutory form is signed by the right party in the right amount, these documents can help mitigate risk from vendors known to the borrower or lender.
Known is a key word however… Requesting proof of payment covering the invoices in a draw request is another mitigation tool. Ensuring funds were in fact disbursed by the borrower or GC is critical, as funds sometimes are withheld for various reasons from exerting leverage over subs to contract disputes. Collecting conditional progress waivers and corresponding proof of payment is a respected approach.Lenders also can use title searches to check for any undisclosed liens or outstanding claims on the property.
This may be done as a stand alone or in conjunction with signed lien waivers. Further, title endorsements can be obtained that provide the added protection of insurance but with added cost and delays to the approval process. Renovation often involves only title searches, whereas new construction likely involves title endorsements and lien waivers (and doubly so for larger budgets and project complexity!).
That said, be sure to tailor any risk mitigation to the situation. Asking for say signed lien waivers from a self performing borrower (i.e., no vendors hired) provides little to no protection since the lien claim filed by borrower against his own loan would be unlikely to hold up in court. Similarly, accepting lien waivers signed by the borrower when there is an independent GC vendor or signed by the GC for their sub’s or supplier’s work does not mitigate lien risk either. Bottom line - Lien waivers used inappropriately are unlikely to provide protection and worse, can damage the customer experience and/or your credibility in the market.
#3: Monitor how the project budget evolves
Knowing the original construction budget size, its uses in terms of line items, and its sources of funds, and changes along the way is critical. This provides a proxy for measuring project scope and a baseline for measuring its progress, as well as insights into the borrower’s judgment.Throughout the construction project, there are often requests to “reallocate” funds and sometimes expand the construction budget through “change orders”.
These are invaluable signals about what is happening on the ground. While tempting to say “not my problem” as a lender and deny, these changes can become your problem quickly if they imperil a borrower’s ability to complete the project. Moreover, these changes can inform you about what is happening on the ground floor and may provide a reason to dig deeper into pending draws.For example, budget changes might reflect a dynamic scope of work, such as the addition of a bathroom or even adding an ADU.
Changes often suggest the project requires more time, making the original schedule inaccurate. Changes could indicate shifts in the market, where the cost to build a four-bedroom house no longer aligns with the original plan or anticipated value.
First and foremost, follow the money. Keeping an auditable history of the original budget and its evolution is foundational to managing the operational risks for active construction.
Better yet, go beyond the money movement to understand what are the underlying drivers, from replacing estimated numbers with contracted rates to unforeseen circumstances (e.g., hidden damage) to new requirements from a code inspection (e.g., retaining wall) to expanding project scope (e.g., adding square footage or structures).
Second, include a contingency line item (often 5-15%) in the budget since renovation and even new construction involves unknowns. If including contingency, keep track of what line items are growing and monitor for excessive consumption too early in the project as that may indicate an inadequate budget or unforeseen circumstances.Third, avoid approving overdrawn line items, the money must come from somewhere.
Source could be from contingency, reallocation from another line item, or additional borrower equity in the case of an expanding budget. If drawing from contingency, consider tracking as a reallocation so you monitor which line items are growing in your budget monitoring.
These are invaluable signals about what is happening on the ground. While tempting to say “not my problem” as a lender and deny, these changes can become your problem quickly if they imperil a borrower’s ability to complete the project. Moreover, these changes can inform you about what is happening on the ground floor and may provide a reason to dig deeper into pending draws.For example, budget changes might reflect a dynamic scope of work, such as the addition of a bathroom or even adding an ADU.
Changes often suggest the project requires more time, making the original schedule inaccurate. Changes could indicate shifts in the market, where the cost to build a four-bedroom house no longer aligns with the original plan or anticipated value.
First and foremost, follow the money. Keeping an auditable history of the original budget and its evolution is foundational to managing the operational risks for active construction.
Better yet, go beyond the money movement to understand what are the underlying drivers, from replacing estimated numbers with contracted rates to unforeseen circumstances (e.g., hidden damage) to new requirements from a code inspection (e.g., retaining wall) to expanding project scope (e.g., adding square footage or structures).
Second, include a contingency line item (often 5-15%) in the budget since renovation and even new construction involves unknowns. If including contingency, keep track of what line items are growing and monitor for excessive consumption too early in the project as that may indicate an inadequate budget or unforeseen circumstances.Third, avoid approving overdrawn line items, the money must come from somewhere.
Source could be from contingency, reallocation from another line item, or additional borrower equity in the case of an expanding budget. If drawing from contingency, consider tracking as a reallocation so you monitor which line items are growing in your budget monitoring.
#4: Compare project pacing with the reported plan and loan maturity
Look beyond the current draw. How does the velocity of draws and project completion compare to the reported completion date and/or loan maturity? Stalled projects without recent draws are often your projects with a higher operational risk. When borrowers are submitting draws, have them reconfirm or update their estimated completion date.
Lenders should anticipate consistent progress toward completion, making delays a clear warning sign of potential risks to meeting the loan's maturity date. Relatedly, before releasing final holdback funds, confirm there is a closed permit and certificate of occupancy if applicable. Keep in mind a temporary certificate of occupancy (TCO) can be rescinded. If the project is not final, push to understand why.
Lenders should anticipate consistent progress toward completion, making delays a clear warning sign of potential risks to meeting the loan's maturity date. Relatedly, before releasing final holdback funds, confirm there is a closed permit and certificate of occupancy if applicable. Keep in mind a temporary certificate of occupancy (TCO) can be rescinded. If the project is not final, push to understand why.
Conclusion
Despite the best of efforts though, challenges will happen. Lenders can bring valuable perspective and expertise to the table informed across a variety of loan types, project sizes, municipalities, and construction related issues.
Automation and predictive analytics powered by software and AI/ML are increasingly in use across the industry and are changing the game for construction lenders in terms of productivity, execution speed, and the customer experience for draw management.
Keep in mind, focusing on customer experience to an extreme exposes you to a higher risk of losses or losing capital providers; while focusing on risk mitigation to an extreme leaves you at a risk of not attracting or retaining customers. Striking the right balance is an active sport.
Engaging early, often, and proactively on any issues increases your chance of success and reduces likely losses whatever path your renovation or construction loan may take. Better to work out solutions while there is money remaining in the holdback and/or while the borrower may have equity funds yet available. In short, keep yourself in the conversation.
Automation and predictive analytics powered by software and AI/ML are increasingly in use across the industry and are changing the game for construction lenders in terms of productivity, execution speed, and the customer experience for draw management.
Keep in mind, focusing on customer experience to an extreme exposes you to a higher risk of losses or losing capital providers; while focusing on risk mitigation to an extreme leaves you at a risk of not attracting or retaining customers. Striking the right balance is an active sport.
Engaging early, often, and proactively on any issues increases your chance of success and reduces likely losses whatever path your renovation or construction loan may take. Better to work out solutions while there is money remaining in the holdback and/or while the borrower may have equity funds yet available. In short, keep yourself in the conversation.