When performing due diligence on a construction loan, lenders should always require a construction contract review as part of an overall plan and cost review (PCR). The contract, after all, is technically between the owner and the general contractor but, as the owner is also the lender’s borrower, it has tangible impacts on the associated risk to the lending institution.
Unfortunately, not all contracts are created equal. I review hundreds of contracts for lenders every year, and I frequently see the same mistakes pop up again and again. Based on those common mistakes, here are five questions your contract review must answer to ensure your investment is adequately protected.
There are a few standard construction contracts that are often used by all parties. The American Institute of Architects has established standard owner/contractor agreements that are valid for most projects, but some owners and builders still choose to create a custom contract. These custom contracts lack the court- and time-tested language of a standard contract, and can contain many unexpected pitfalls for owners and lenders. These should be carefully reviewed by an expert, and even then, the terms as you understand them may not hold up in court.
Bonding should be a standard element of a contract, but sometimes it’s not. Without a performance bond, a contractor may simply walk off the job, leaving the owner scrambling to complete the project. Likewise, a payment bond should be provided, insuring that all subcontractors and material suppliers are paid, even if the contractor neglects to do so. Construction contracts also often specify insurance coverages without defining adequate limits to cover the project in the event of problems. The coverage limits should always be spelled out in the contract.
I see payment term problems more often than any other contract mistake. The payment terms are often either too generous or too restricted, generally depending on who wrote the contract. Obviously, the contractor wants to get paid as early and as fast as possible, while it’s in the owner’s (and the lender’s) interest to ensure that the payment timeline is realistic in terms of the lender’s ability to process the payment. I’ve seen contracts that require the contractor be paid in as little as five days after they submit their monthly draw, clearly not sufficient time for the lender to complete all of the activities they require to fund the draw. While payment terms must make it possible for the contractor to obtain materials and pay their subs in a timely fashion, a too-fast payment term risks putting the owner in default when they can’t pay in time. In general, an appropriate payment term is twenty to thirty days.
A healthy contract withholds some of the contractor’s payments until certain milestones are met. Typically, our suggestion is to hold 10% until the project is 50% complete, and then 5% until the project is complete and signed off. The retainage helps to ensure that the contractor completes the job and in a workmanlike manner. Surprisingly, we often see contracts with no retainage specified at all, which is a risky situation for the owner and lender.
Every day that a project remains incomplete represents lost revenue for the owner and increased risk for the lender. A liquidated damages clause requires the contractor to pay the owner a set amount per day for every day past the date that the contractor has agreed to complete the project. This is an incentive for the contractor to finish on time, as well as a financial buffer for the owner, ensuring that they are able to recognize anticipated revenue while the building continues to sit unfinished. Be aware that in order to collect liquidated damages, the owner must be able to prove actual loss associated with the delay.
Every week, I see contracts that contain unnecessary risks for owners and lenders. A qualified PCR company will help protect your investment by expertly reviewing the contract for these and other problems. A complete PCR also includes a review of the construction drawings, which you can find out more about here.
Looking for an experienced, reputable, nationwide PCR firm to meet your institution’s needs? Call GLE today.