Commercial Real Estate Loans Due Diligence
The funding source looks to the project as collateral for the loan, as well as for its source of repayment. Four broad categories of risk create dangers that are inherent in construction lending. These are:
1. The risk of construction difficulties caused by:
- Undisclosed or undiscovered site characteristics, such as bad drainage or unstable soils conditions;
- Structural problems arising from inadequate or incompetent engineering and/or design;
- Neighborhood resistance, which results in delays due to an inability to obtain required governmental approvals and permits; and
- Environmental problems.
2. The developer’s financing becomes inadequate due to cost overruns resulting from:
- Change in building materials and labor markets;
- Changes in costs (or failure to estimate costs properly); and
- Unexpected increases in financing costs, which depletes the interest reserve. (The construction lender must guard against diversion of loan proceeds to other projects and then make sure there is adequate funding to cover landscaping and maintenance.)
3. Even if fully completed, the project may not be financially successful because:
- The cost of construction may exceed market value.
- Leasing or selling the project may be difficult due to local market conditions.
- The developer may fail on another project, resulting in financial distress (perhaps bankruptcy) and the inability to complete this project.
- A change in economic conditions beyond the control of the borrower.
4. There is always the risk of a legally invalid security position.