Best Practices for Managing Risk in Construction Lending

Commercial real estate development is white hot. Cranes are back in many cities and more construction projects are in the works. Developers who survived the downturn are stronger today and seem to be getting as many, if not more, concessions as they did prior to the crisis. A bank’s credit structure for commercial real estate lending and construction administration function need to be ready to manage today’s new realities and expectations.

D. Scott Dixon, Sr. vice president/senior credit officer, Commercial Real Estate - Portfolio Analytics & Governance, SunTrust Banks, Inc., discussed best practices for ensuring that a bank’s credit appetite is in synch with its operating risk structure during RMA’s latest installment of the Credit Risk Management Audio Conference Series.

Dixon considered commercial real estate lending and construction lending in the framework of risk. The fundamental risks in income-property construction lending include:

  • Borrower/sponsor risk.
  • Construction and completion risk.
  • Leasing and stabilization risk.
  • Refinancing/repayment risk.
  • Market and demographic risk.
  • Property location and competitive risk.

He stressed the importance of lenders being comfortable with their borrower, i.e., is the borrower using quality construction resources and is he/she a reliable contractor? Dixon recommended that lenders should determine if their borrower aligns with their client strategy and develop a strategy if they don’t have one.

Construction lending is often considered risky because of factors pertaining to the completion process, like determining specifications, understanding local codes and ordinances, and knowing when new ones are on the horizon. With labor and material costs increasing on construction projects, it is important to check in with the developer about the budget. It’s also considered best practice to engage an independent architect or engineer to monitor monthly inspections of the site.

Regarding risks related to leasing, Dixon advised lenders to be cautious when underwriting market rates. With forecasts of a recession in the next 12–24 months, rent rates are not likely to increase unless it’s a particularly hot market.

Refinancing/repayment risk is becoming more significant due to rising interest rates. Dixon advised including a cushion in underwriting interest rates and determining a minimum DSCR.

To conclude the presentation, Dixon offered general ways for lenders to mitigate risk including diligence in underwriting, evaluation of a borrower’s competence, and thoughtful structuring of loans that align with the institution’s risk tolerance and match lender/borrower expectations.

Join us for the next installment of the Credit Risk Management Audio Conference Series on February 12, Community Bank CCO Panel Discussion.

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