Construction or renovation lending is unique within the broader world of mortgage and asset-backed lending. Unlike financing a car or an existing home purchase, financing construction or renovation requires underwriting a borrower and an asset in the making. Construction and renovation involve countless moving parts and stakeholders and, accordingly, countless vectors for project failure.
As the adage goes, construction projects take twice the time and twice the budget expected. Operational risk management is about monitoring and adapting to protect the capital you have at risk.
This article focuses is on business-purpose loans (BPL) in construction lending for “resi-mercial” with its broader meaningof renovation through new construction of single-family or multifamily housing.
As the adage goes, construction projects take twice the time and twice the budget expected. Operational risk management is about monitoring and adapting to protect the capital you have at risk.
This article focuses is on business-purpose loans (BPL) in construction lending for “resi-mercial” with its broader meaningof renovation through new construction of single-family or multifamily housing.
Operational Risk Basics In Lending
When most lenders hear “risk” in the context of a loan, they immediately think about credit risk: the possibility of a financial loss to the lender if a borrower fails to repay or fulfill the contractual obligations of a loan. Yet credit risk is only part of the story. Its shadowy counterpart is operational risk, namely the possibility of financial loss or repetitional damage due to internal processes, people, or systems that are inadequate, or from external events beyond the lender’s control.
Let’s look at a fun analogy that illustrates how and why operational risk matters in resi-mercial construction lending: the funding of a movie production. A movie production starts with an idea, and real- time adjustments (often many) are made along the way. It has a budget and timeline, though both are notoriously hard to forecast. The movie becomes “real” at some point, yet only the market will tell you if it’s successful. Further, the project involves a long list of credits with countless stakeholders, each playing a unique role.
By definition, complexity is added with each layer, and operational risk increases as well. From writers to actors to directors and producers, every additional party in a movie introduces new dynamics that can either complicate the process or contribute to its success. Miscoordination and misalignment are common. Not all movies are completed. Despite best efforts, successfully completing the movie may still lead to financial failure. In short, a lot can go wrong.
Similarly, a resi-mercial construction project involves multiple layers and complexities, introducing the potential for significant operational risks. Projects often involve a loan buyer or warehouse lender, originating lender, owner-developer, general contractor, subcontractors, and suppliers, not to mention external parties such as code inspectors, progress inspectors, and even neighbors!
As with a movie, completing construction and selling or renting the newly finished asset does not guarantee success. To make matters worse, some parties may even have the right to file a lien against the property despite being indirectly related to the project and/or completely unknown to you as the lender—or even your borrower.
Remember, any party involved in the loan or its underlying project can introduce operational risk. This means operational risk is not limited to a lender’s processes, people, and systems. It can include any party involved in the project, from borrowers to contractors and beyond.
Let’s look at a fun analogy that illustrates how and why operational risk matters in resi-mercial construction lending: the funding of a movie production. A movie production starts with an idea, and real- time adjustments (often many) are made along the way. It has a budget and timeline, though both are notoriously hard to forecast. The movie becomes “real” at some point, yet only the market will tell you if it’s successful. Further, the project involves a long list of credits with countless stakeholders, each playing a unique role.
By definition, complexity is added with each layer, and operational risk increases as well. From writers to actors to directors and producers, every additional party in a movie introduces new dynamics that can either complicate the process or contribute to its success. Miscoordination and misalignment are common. Not all movies are completed. Despite best efforts, successfully completing the movie may still lead to financial failure. In short, a lot can go wrong.
Similarly, a resi-mercial construction project involves multiple layers and complexities, introducing the potential for significant operational risks. Projects often involve a loan buyer or warehouse lender, originating lender, owner-developer, general contractor, subcontractors, and suppliers, not to mention external parties such as code inspectors, progress inspectors, and even neighbors!
As with a movie, completing construction and selling or renting the newly finished asset does not guarantee success. To make matters worse, some parties may even have the right to file a lien against the property despite being indirectly related to the project and/or completely unknown to you as the lender—or even your borrower.
Remember, any party involved in the loan or its underlying project can introduce operational risk. This means operational risk is not limited to a lender’s processes, people, and systems. It can include any party involved in the project, from borrowers to contractors and beyond.
What Operational Risks Look Like
Below are common operational risk factors seen in construction or renovation loans. Keep in mind these are farfrom comprehensive and intended to raise awareness through tangible examples based on real experiences.
Reductions In Borrower Cash Flow
Most suppliers and trades will require deposits to create an order or get a spot on the schedule. For example, many window manufacturers require a 50% deposit upfront and the remainder upon delivery. Beyond these initial deposits, you should also build in a buffer for unexpected changes in supply chain costs, as seen with COVID-era lumber costs or rebuilding after extreme weather.Finally, changes on another construction project can impact shared stakeholders, leading to a contagion effect. Borrowers and contractors in financial distress may try to use unrelated funds, including taking cash from a healthy construction project in your loan to cover somewhere else.
Increases To Project Budgets Or Timelines
Beyond garden-variety scope creep, two of the most common culprits that increase time and cost are code inspections that create significant new work (such as installation of a retaining wall wall) and supply-chain delays, changes, or errors. Intermittent weather, such as cold periods preventing concrete cure, can also cause short-term wait periods that cascade dependent projects.
Meanwhile, fire, theft, vandalism, and site damage from natural disasters are less common on a per-project basis but more likely at scale/across a portfolio.
Lenders should also be aware that their own processes can fumble the timeline, such as ordering a progress inspection outside of the regular scope intervals already planned.
Across all these possibilities, general contractors and other vendors may require regular overhead payments to retain services, regardless of the reason for delay.
Meanwhile, fire, theft, vandalism, and site damage from natural disasters are less common on a per-project basis but more likely at scale/across a portfolio.
Lenders should also be aware that their own processes can fumble the timeline, such as ordering a progress inspection outside of the regular scope intervals already planned.
Across all these possibilities, general contractors and other vendors may require regular overhead payments to retain services, regardless of the reason for delay.
Liens
Mechanics liens are the bane of any project: not only may your borrower have payment disputes with their general contractor, but that GC may have disputes with vendors, subcontractors, and even their subonctractor’s subcontractor. Parties neither you nor the borrower are aware of but who performed work or delivered supplies may have valid claims for payment.
Weaknesses In Fund Control Processes
Beyond human error, inconsistent lead to sending additional funds after the processes create room for discrepancies. For example, if the inspection order lacks scope-related context, you may then document an inaccurate view of completion. Further, missing or incomplete supporting documentation may violate fund control policy or capital provider reporting requirements, while funding draws without knowing the latest servicing status may lead to sending additional funds after the borrower has requested early payoff.
Fraud
Borrowers and/or related parties may seek to misrepresent or obfuscate a project in any number of ways, including misleading photos to prove completion status, falsifying lien waivers, misleading the inspector as to unit number or address, or even colluding directly with the inspector to falsify a completion report.
Legal Or Compliance Issues
Challenges between lender and borrower include disputes over approved changes or draw amounts, especially if this reduces the draw or impacts their interest charges. Meanwhile, disagreements between the borrower and their contractors or suppliers may result in legal or code compliance complications.
Cyber Threats
These threats often take the form of ransomware and other attacks.
New Construction Versus Renovations
Keep in mind that although construction and renovation share some operational risks, they have critical nuisances. For example, new construction, additions, or major renovations may involve required permits, plans, insurance coverages, and local government code inspections. In contrast, renovations generally involve going backward in terms of asset value before going forward (e.g., mid-rough phase project may be worth less than its starting point).
Although some operational risk factors will always be out of your control (by definition!), you can make informed and strategic choices about your mitigation plan. Talk openly with your team about which factors are relevant to your portfolio. Ask questions and explore any mitigations you believe are in place. Objectively assess your residual exposures by operational risk factor, ideally every quarter. Inherent in successful operational risk management are transparency, systematic oversight, and well-chosen technology and partners to help. Don’t avoid operational risks—they are real and can hurt you, your clients, and your investors.
As a construction or renovation lender, your ability to monitor and manage operational risks can significantly influence your portfolio performance, client experience, and ability to scale. Although thoughtful credit risk decisions set the stage for success, proactive operational risk management during the performance helps ensure success is realizable.
Although some operational risk factors will always be out of your control (by definition!), you can make informed and strategic choices about your mitigation plan. Talk openly with your team about which factors are relevant to your portfolio. Ask questions and explore any mitigations you believe are in place. Objectively assess your residual exposures by operational risk factor, ideally every quarter. Inherent in successful operational risk management are transparency, systematic oversight, and well-chosen technology and partners to help. Don’t avoid operational risks—they are real and can hurt you, your clients, and your investors.
As a construction or renovation lender, your ability to monitor and manage operational risks can significantly influence your portfolio performance, client experience, and ability to scale. Although thoughtful credit risk decisions set the stage for success, proactive operational risk management during the performance helps ensure success is realizable.