NCUA regulation § 723.6, Construction and development loans, defines a C&D loan as any financing arrangement that allows a borrower to acquire property or rights to property (including land or structures) with the intent to construct or renovate an income-producing or commercial property.
An income-producing property is a property that generates income from the rental or sale of the units constructed; loan proceeds and the repayment of a C&D loan for an income-producing property depends on the successful completion of a project (such as residential rental properties, non-owner occupied 1-4 family, leased office space, leased rental space, construction and sale of units for resale in a development etc.)
Commercial property is a term that applies to structures used for commercial, agricultural, industrial, or a similar purpose that do not directly generate income, but enhance operations (such as a warehouse, manufacturing facility, and management office space).
NCUA regulation § 723.6, Construction and development loans, provides that a loan that finances maintenance, repairs, or improvements to an existing income-producing property that does not change the property’s use or materially impact the property is not a C&D loan.
For a C&D loan, the ultimate valuation of the project and collateral protection depends on the satisfactory completion of the project within budget and as planned. The full value of collateral for C&D loan does not exist at the time a credit union grants the loan. Instead, collateral value is created as improvements to the real estate occurs. As the collateral value increases during the progressing stages of construction (as improvements occur) or as a result of the project’s completion, it is a prudent practice to control and manage loan disbursements in a way that ensures the funding is applied to the project as agreed and that the project can be completed as planned.
Income Producing and Commercial Purpose Properties
NCUA regulations distinguish between income-producing property and projects built for a commercial purpose. This is necessary for a credit union to determine the duration of the financing period, as established in § 723.6(b)(2) under the prospective market value method of valuing a construction project.
For income producing properties, the financing period generally ends on the “as stabilized” date. For commercial-purpose properties, the financing period generally ends on the “as completed” date. Determining these dates is discussed in the prospective market value section of the Examiner's Guide. Establishing the date construction period ends is also necessary so a credit union can monitor the progress of a project.
To provide C&D financing, a credit union must have specialized expertise and a sound construction loan administration function. Due diligence for C&D loans involves not only a financial analysis of a borrower, but a comprehensive assessment of the economic purpose and feasibility of a construction project. Because the underlying purpose of a construction project is to create economic value greater than a borrower’s development costs, a credit union must be able to obtain or generate a reliable forecast of a project’s potential based on prospective market conditions.
Due Diligence Analysis
Borrower Creditworthiness
A credit union’s risk assessment of a construction loan begins with its analysis of a borrower’s financial condition. This must be done in accordance with the underwriting standards set forth in the credit union’s commercial loan policy. For more information, see NCUA regulation §723.4, Commercial loan policy. A comprehensive financial analysis is necessary to determine whether a borrower has sufficient capacity to repay a loan.
Feasibility
Assessing the feasibility of a proposed project is central to a credit union’s due diligence analysis. Because construction financing often funds a change in an existing business operation, a credit union’s determination about a project’s feasibility and success will strongly influence its conclusion about a borrower’s ability to repay. This determination will also impact how a credit union values a construction project as collateral for a loan.
Feasibility describes the likelihood that a proposed project will be economically successful.
A credit union can include feasibility studies as part of an independent appraisal or in a separate analysis. While a borrower can initiate a feasibility study, a credit union should ensure that a study’s conclusions are independent of any undue influence from a borrower by commissioning an independent study. Appraisals can be useful to support a feasibility analysis, but are not always the sole basis for assessing a proposed project’s feasibility. A credit union should require additional analysis if it is uncomfortable with the feasibility analysis in the appraisal or determines additional information is warranted.
Monitoring Borrowers
A credit union that makes C&D loans needs an effective system to monitor the financial condition of borrowers and the progress of projects. Construction financing requires adherence to an accurate budget and timetable. Deviations from the construction budget and schedule can result in extra cost and adversely impact the feasibility of the project.
To protect against deviations from the construction budget and schedule, a credit union should have policies and procedures in place to ensure the loan administration process is designed to fit each project and monitor that it is on track with the approved budget and construction schedule. A properly administered program will include specified procedures for tracking and monitoring construction phases and the scheduled loan disbursements.
Diligent administration of the construction loan disbursement process by the credit unions helps protect a credit union against losses that can arise from:
- Inappropriate use of loan proceeds
- Intervening liens from other creditors
- Failure to complete construction
- Failure to build to agreed-upon specifications
- Cost overruns, and
- Other unexpected developments that adversely impact a project
For more information, see the administration and loan disbursements section of this guidance.
Project Valuation
Appropriately valuing a project is a key component to a successful C&D loan. NCUA regulation §723.6(b) outlines the requirements for valuing collateral for a C&D loan and managing the loan process. The rule also requires that a federally insured credit union’s commercial loan policy includes adequate provisions to value the collateral.
NCUA regulations require a credit union to determine the valuation of C&D collateral using the lesser of the cost to complete a project or the prospective value of a project. Using the lesser of these two values ensures the risks associated with a transaction are appropriately shared between the lender and borrower. It eliminates the potential that a borrower could benefit from an inflated appraisal or unearned appreciation, and ensures that the required contribution of the borrower is a capital investment.
Cost to Complete
NCUA regulation § 723.6(b)(1) defines cost to complete as:
“…the sum of all qualifying costs necessary to complete a construction project and documented in an approved construction budget. Qualifying costs generally include onsite or offsite improvements, building construction, other reasonable and customary costs paid to construct or improve a project, including general contractor’s fees, and other expenses normally included in a construction contract such as bonding and contractor insurance. Qualifying costs include the value of the land, determined as the lesser of appraised market value or purchase price plus the cost of any improvements1. Qualifying costs also include interest2, a contingency account to fund unanticipated overruns, and other development costs such as fees and related pre-development expenses. Interest expense is a qualifying cost only to the extent it is included in the construction budget and is calculated based on the projected changes in the loan balance up to the expected ‘‘as- complete’’ date for owner-occupied non- income producing commercial real estate or the ‘‘as-stabilized’’ date for income producing real estate. Project costs for related parties, such as developer fees3, leasing expenses, brokerage commissions, and management fees, are included in qualifying costs only if reasonable in comparison to the cost of similar services from a third party. Qualifying costs exclude interest or preferred returns payable to equity partners or subordinated debt holders, the developer’s general corporate overhead, and selling costs to be funded out of sales proceeds such as brokerage commissions and other closing costs4.”
Prospective Market Value
Prospective market value is the value assigned to a project at a future date, and is based on a prospective value appraisal. A prospective market value requires a market value opinion as determined by an independent appraiser in compliance with the relevant standards set forth in the Uniform Standards of Professional Appraisal Practice (USPAP). Prospective value opinions are intended to reflect the current expectations and perceptions of market participants, based on available data.
Two prospective value opinions may be required to reflect the timeframe during which development, construction, and occupancy occur. The prospective market value for “as-completed” reflects a property’s market value as of the time the construction is to be finished. The prospective market value “as-stabilized” reflects a property’s market value as of the time the property is projected to achieve stabilized occupancy. For an income-producing property, stabilized occupancy is the occupancy level that a property is expected to achieve after the property is exposed to the market for lease over a reasonable period of time and at comparable terms and conditions to other similar properties.
In most cases, the prospective market value will exceed the cost to complete value of a project. The economic purpose of developing a property is to create value over and above a project’s cost. The difference between the prospective value and cost to complete value is the developer’s profit— the incentive required by a developer to assume the risk of construction and sale (or lease-up).
Developer’s profit will vary depending on a development’s complexity and risk. A development that does not create this economic incentive is generally not feasible, because the prospective value won’t recover construction costs. Furthermore, a project budget with little or no developer profit leaves insufficient room for cost overruns. A credit union that is forced take possession of an incomplete project will have difficulty disposing of a property due to the lack of profit margin when prospective buyers understand the economics of the situation. A credit union in these circumstances may be forced to incur unplanned expenses to complete a project or sell it at a loss.
A prospective market appraisal that is lower than a cost to complete value indicates that a project may be overbuilt for current market conditions. A credit union should require a borrower or principal, in addition to the required equity investment, to pay for the portion of the cost to complete that exceeds the prospective market value. Establishing a borrower’s investment requirement based on the lesser of cost to complete or prospective market value will ensure a borrower infuses sufficient capital and it establishes a stronger economic incentive and commitment on the part of the borrower to successfully complete the project.
Administration and Loan Disbursements
Controlling disbursements is a key component to a successful C&D loan. NCUA regulation § 723.6, Construction and development loans, requires federally insured credit unions that elect to make a C&D loan to require in the following conditions in their policy:
- Qualified personnel representing the interests of the federally insured credit union must conduct a review and approval of any line item construction budget before closing the loan
- A credit union approved requisition and loan disbursement process is established
- Release or disbursement of loan funds occurs only after onsite inspections, documented in a written report by qualified personnel representing the interests of the federally insured credit union, certifying that the work requisitioned for payment has been satisfactorily completed, and the remaining funds available to be disbursed from the C&D loan is sufficient to complete the project
- Each loan disbursement is subject to confirmation that no intervening liens have been filed
C&D loans require more frequent and intensive loan administration by a lender than a loan provided for the sole purpose of purchasing real estate. However, C&D loans contain prospective or future risk with respect to whether a project is completed and within a borrower’s projected timetable and budget.
A credit union manages this risk by having separate policies, procedures, and experienced staff to guide and oversee the construction phase of a loan. A credit union can supplement staff expertise with third-party experts. While a third party can provide the necessary expertise in evaluating the construction process, a credit union should have sufficient expertise on staff to understand the work and analysis done by the third party. A credit union should also be able to oversee the performance of the third party and verify that its activities comply with the credit union’s policies.
Budget
Before closing on a C&D loan, a borrower should submit a line item budget of the expected expenses to complete the project. The budget is generally part of the construction contract between a borrower and a contractor. NCUA regulations require a qualified individual representing the credit union review, analyze and approve the budget before the construction loan closes. A qualified individual should have experience in managing construction, specifically in budgeting and evaluating the quality of workmanship. They are often building inspectors, other commercial contractors, architects, or civil engineers.
A budget review should confirm the cost to complete provided by a borrower is a reasonable estimate (supported with executed contracts with the subcontractors and material suppliers), determine whether improvements are in accordance with the plans, and assess whether the improvements are sufficiently functional and compare favorably with competitive properties in its market. A credit union should be skeptical of borrower-produced budgets that lack detail or appear to be overly optimistic. An inaccurate budget can lead to material cost overruns and cause a need to advance additional and unplanned funds to complete the project. Cost overruns are a risk to a credit union, as they are rarely offset by a corresponding increase in a project’s value.
See Cost to Complete for more information.
Disbursements Process
Because construction projects happen in phases, construction loans are dynamic. A credit union should structure C&D loans with a series of disbursements that are scheduled to coincide with the projected progress of the construction. NCUA regulation § 723.6(c)(3) requires a credit union to certify completion before disbursement. Disbursements should also be subject to a credit union’s verification that a project is on schedule, and that the quality of the construction or work is satisfactory and according to the plans provided to the credit union. The failure to adequately administer a construction loan can lead to credit union losses that are otherwise avoidable.
After a credit union approves a project budget, it should review the project timeline and establish a projected disbursement schedule. The disbursement schedule should be determined based on the agreed-upon timeline between the borrower and the contractor. It is general practice for disbursements (also known as progress payments) to be made monthly, and to be based on the estimated work to be completed during the month.
A deviation (delay) from the disbursement schedule may be any early sign a project is faltering or experiencing trouble. When a credit union detects a deviation from the projected disbursements schedule and expects a change in the planned construction completion date, it should give the situation immediate attention and take appropriate action to determine how the borrower plans to get the project back on schedule. Corrective action can take the form of rescheduling future disbursements if the reason for the change does not materially impact the completion of the project. It may also take the form of renegotiating the loan administration if there is risk the project may not be completed within the approved budget and schedule.
Interest funding requires special attention and monitoring by the credit union. Inappropriately administered interest funding can mask a poorly performing project and increase a credit union’s loss exposure. If the budgeted interest amount is exhausted before the end of the construction period due to a change in market condition or construction delays during the construction period, the borrower or principals should provide the funding of interest payments. Also, payments of interest after the construction period ends should be made by the borrower or principals, and should not be funded from loan proceeds. Examiners should closely scrutinize funding of interest.
Credit unions and borrowers should agree on the process for handling and paying adjustments to the disbursement schedule and budget. These changes are submitted through change orders to a project. The work associated with the change order does not necessarily add any value to the project. Unless there is a contingency in the budget to handle change orders, a borrower or principal should pay unexpected change orders, as well as any change orders that exceed the budgeted amount. Paying unbudgeted change orders from the construction budget may result in insufficient funding to complete a project.
A requisition, or construction draw, is a funding request a borrower submits to the credit union. There is not a standard format for a construction draw. It is sound industry practice for a borrower to include the following information when submitting a construction draw:
- Original contract amount, reconciled against all advances to date
- Amount of requisition, itemized and reconciled to the line-item budget
- Certification that all work covered by the requisition is complete
- Reconciliation of change orders
- Certification that all subcontractors and material suppliers have been paid, and
- Certification the borrower is in compliance with the terms of the construction loan agreement
A lender normally retains 10 to 20 percent of each payment to cover project cost overruns or outstanding bills from suppliers or subcontractors. This hold back is also known as retainage, and serves as a form of performance incentive for borrowers and contractors.
A credit union’s C&D loan policy should require that any equity be contributed before disbursements of a C&D loan begin. When the injection of any equity is deferred for contribution to a later point in the construction process, a credit union should be assured that this equity is, and will remain, available. Allowing the deferred contribution of equity can significantly increase completion risk, and should not be routinely allowed or allowed in the absence of compelling mitigating factors.
The final draw on a commercial construction loan usually includes payment of the retainage, as stipulated in the loan agreement. A borrower will use the final draw to pay all remaining expenses. A credit union should also obtain and review the final inspection report from the project to confirm that the project is complete and meets building specifications. This report will also help a credit union confirm that the builder has obtained a certificate of occupancy from the governing building authority, if necessary.
Pre-Disbursement Inspection and Report
Upon receipt of a requisition, and before disbursement, a credit union should have a qualified inspector visit a project to evaluate its progress. The inspector will determine if:
- Work represented as “complete” in the requisition request has been performed
- Confirm that previous requisitions have been paid to all subcontractors and material suppliers
- Work is satisfactory
- Project is still within budget
- Remaining budget is sufficient to complete the project
Inspection results should be documented in an organized and official report. The report should include a certification and approval of the inspector authorizing the payment of the requisition, or the payment of an adjusted amount if the inspector deems the requisitioned work has not been completed or is unsatisfactory in quality. An inspector report generally covers the following:
- Confirmation the work to date as requisitioned by the borrower is complete and is in satisfactory condition
- Confirmation of the progress to date, compared to the agreed-upon disbursement schedule
- Confirmation that materials on hand are as requisitioned and are adequately protected and properly secured
- Pictures of the project to record and document progress
- Confirmation that all necessary disclosures required by local jurisdiction are properly posted at the job site (including a picture of disclosures)
- Confirmation that construction-to-date is in accordance with approved plans
- Confirmation that subcontractors and material suppliers have been paid to date (document lien waivers from contractor and sub-contractors for work paid from previous requisitions)
- Analysis of change orders to date and the impact on the project
- Confirmation that remaining funds available from the loan and borrower are sufficient to complete the project
- Confirmation the borrower and project are in compliance with any other credit union requirements specific to the loan
A qualified inspector plays an important role in ensuring a construction project is managed correctly. However, a credit union should not rely solely on an inspector. A well-managed construction project requires a lender to perform periodic inspections to ensure a project is on track.
Such inspections can also detect early signs of distress. By conducting regular inspections, a lender will note common signs of distress such as a lack of activity, minimal progress made since the last visit, the condition and tidiness of the jobsite, the overall organization of the project, and if its construction is workmanlike.
A credit union should also monitor the administration of loan advances for variance from the agreed-upon disbursement schedule and for adherence to the approved line item budget. It should develop a separate accounting procedure for tracking the disbursement against the line item budget amounts. Any variance from the budget should immediately be discussed with the borrower to ensure the project stays on track.
Intervening Liens
A construction loan is advanced over a period of time and in increments (payments) as a project progresses. Payments are made to a borrower or to a construction manager (if directed by the borrower) to be further allocated and paid to subcontractors and material suppliers. If they are not paid as represented in the requisition, the subcontractors and material suppliers have the right to take action and make a claim against the project. These claims are called a mechanic’s or materialman lien. Such a claim would supersede the collateral lien position of future advances on the loan. The laws governing these liens are specific to the state in which a construction project is located. Credit unions should be familiar with the state laws and procedures for mechanic and materialman’s liens. An inspector should collect lien waivers from the contractor, subcontractor and material suppliers for work paid from previous requisitions before approving any disbursement.
Credit unions must also follow the requirements of any title insurance provider. This includes certifying there have not been any intervening liens since the last advance or title certification. This certification is referred to as a date down endorsement to the title policy. A credit union should be familiar with its title insurance requirements and ensure it has the policy and procedures in place to remain compliant. Intervening liens weaken a credit union’s collateral protection. This can impact the timely completion of a project and adversely impact the protection provided by the title insurance.
Before releasing the final draw and disbursing the retainage, a credit union should confirm that a borrower has obtained all waivers of liens or releases from the project’s contractors, subcontractors, and suppliers and that a borrower is in compliance with all requirements to maintain title insurance.
Last updated November 25, 2016
