March 2, 2016
by Walter McLaughlin
Contributor, Coleman Report
C-Suite Wednesday — Five Need-to-Know Tips on SBA Construction Loans
As we all are aware, SBA lending is a unique, highly-specialized niche. Less obvious but equally intuitive: so is construction lending. Put the two together and you have a challenging mix that offers great rewards at an elevated risk, one which can spin out of control if proper safeguards are not in place.
As lenders, we often explore how to hold the risk to a manageable level. That led me a conversation with George Casady from GMC-CMI, a construction management firm in Seattle, Washington that performs progress payment inspections, constructability analysis and budget reviews throughout the western U.S. From our conversation I determined five areas of focus that are considered key to a successful project:
Budget wisely. It may seem like an obvious point, but too many problems occur when the bank is partially through disbursement of construction proceeds and the project begins to run short of funds, either because of unexpected change orders, line item mistakes or other fundamental flaws. For larger and/or more complex projects, a constructability analysis can help identify obstacles, prevent errors and minimize delays and potential cost overruns. Well-prepared budgets are arranged in components that can be measured by percentage of work completed. Borrowers should be advised to make reasonable requests for progress payment draws, and to avoid over-disbursing, their draws should be supported by actual work completed. If funds are disbursed by percentage of work completed, it is unlikely that over-disbursing will occur.
Contingency for cost overruns. Despite everyone’s best efforts, sometimes overruns happen. To prevent a significant overrun from breaking the budget, consider holding a 10% contingency in reserve until the project is completed. Although the amount of a contingency is not limited in the 50 10 5 (H) on the 7(a) side, it’s specifically cited as the maximum allowed under the 504 program. Remember, very few projects occur that have no “change order” impacts. It is far easier to address unknown or unforeseen additional costs if a funding source is provided at the start of the project.
Inspectors are your friends. Although we all like to save the borrower money and speed up processes whenever possible, very few lenders are construction experts. Even though the 50 10 5 (H) allows the Lender to largely follow its own policies and procedures for amounts up to $350,000, it is generally not a good idea to allow the Relationship Managers to moonlight as the project’s inspector, especially for any significant dollar amount and with an SBA guaranty on the line. Outside inspection firms (known as third party) add an impartial view of the project. Just as importantly, they provide the Lender with critical information about the project, its development progress and make recommendations as to the percentage of work completed.
For loans above $350,000, an outside firm’s services must be utilized unless the contractor supplies a 100% performance bond, as outlined in the 50 10 5 (H) SOP as follows:
“SBA has granted a blanket waiver on the requirement of a performance bond when a third party in the business of providing construction management services controls the disbursement of the proceeds. Lender must document in its file that the construction was completed in conformance with the plans and specifications and that all lien waivers and releases from all material men, contractors, and subcontractors involved in the construction have been obtained.”
Encourage the client to heed caution. All borrowers are understandably eager to get their project up and finished as quickly as possible. After all, time is money as the saying goes, and every extra day has both direct and opportunity costs associated with it.
That being said, another saying is equally appropriate here: haste makes waste. An overly-aggressive borrower is more inclined to make hasty (thus, costly) decisions, which can eat into his/her reserves and cause stress to your construction budget. A constructability analysis with a budget review included is good insurance and documentation to have, and can alert the Lender of considerations that should be made, prior to entering into the loan agreement.
Lien releases are critical. The process of securing the correct lien waivers can be confusing or even intimidating, but is nevertheless critical to protecting your security position and ensuring the bank is in control of the project. For the most part, unconditional lien waivers should be requires, with an unconditional final release as a condition of final payment after all the work is complete. In spite of the fact that lien waivers seem complicated, when used properly, they become the most effective tool the Lender has to manage the actual risk that occurs after the loan funds are disbursed. Waivers are the only absolute assurances the Lender has that sub-tier contractors, suppliers and others have been paid.
There is plenty more to think about when offering SBA construction loans, but protecting yourselves and the borrower should be at the very top of the list. As actress Lily Tomlin once wrote, “The road to success is always under construction.”