What to Expect When Funding Residential Construction Projects In The Caribbean
We discuss what is the best approach for Residential Real Estate Development Financing:
What You’ll Need to Have Ready
What Are the likely Costs
What Lenders will expect during the Project
You've bought your ‘piece o’ da rock’ on your chosen Caribbean Island, now you want to build your Dream Villa.
What do you need to consider when looking to obtain Development Financing for your project?
What are Lenders Looking For?
When you have identified a Lender, whether through a Broker or directly from a Local Bank or Lender, it is important to understand what key information you will need to provide and what you should be prepared to know.
The Lender will assess both the Borrower and the Proposed Development Project when considering extending a Construction Loan.
This assessment, known as underwriting, involves evaluating the ability of the Borrower and/or the Project to repay the loan.
Key factors that the Lender will consider during underwriting include the financial stability of the Borrower, the feasibility and potential success of the Development Project, and other relevant information that demonstrates the ability to meet loan repayment obligations.
The Borrower's creditworthiness
The market feasibility of the project, and the likelihood that the villa will be completed, and able to be sold for a sufficient value, to repay the loan if the security is actioned
The value of any collateral or security, such as the land, mortgages, personal guarantees.
The qualifications, experience and expertise of the participants, including the owner, developer, architect, project manager and key contractor
To help be prepared for a successful Construction Loan Application, we’ve detailed the information you should have ready to include in the proposal to Lenders here in the Caribbean, along with the outline costs & fees involved when making a successful application for development finance.
The Funding Proposal
The Lender takes on more risk with development finance compared to a standard mortgage or real estate loan. They assess the Borrower's suitability by conducting due diligence on their experience, creditworthiness, and the key developers or contractors involved in the project.
The following information is typically required when presenting an application to a Lender:
Purchase agreement and price, or legal ownership documents, including lot plan for the land
Site description, location, and area analysis, with supporting As-Is Market Value of lot or existing property
Architect's summary presentation of the project, including renderings of the finished property and a written summary of what the completed project will be
Projected internal floor areas of the differing elements, along with the original design brief from the client and how it has been met with the design
Planning permission documents and approvals, approved plans, zoning or compliance with development plan, including any restrictions, conditions, or obligations
Details of the developer and/or key contractor's property development experience, including successful projects and projects that may not have been a success
Challenges previously experienced in this type of development, key risks and threats, and how they were overcome
Demonstration of development and market knowledge and experience gained
Specifics relating to subcontractors such as architects, planners, and builders, including their experience and past projects
A detailed breakdown of build costs, including:
○ Labour and materials,
○ Agreed contracts,
○ Materials purchasing agreements,
○ Mobilisation payments,
○ Provisional sums, and
○ Retention agreements
A schedule of the works to be carried out, including:
○ Expected timeline,
○ Development stages, and
○ Milestone points or payments
A contingency plan & allowance, to provide for possible delays and how they will be resolved, considering extreme weather events such as hurricanes or flooding.
Building regulations and building plan approvals
The projected value of the project when completed, known as the Gross Development Value (GDV) or Market Value on Special Assumption that Identified Works have been Completed.
The expected costs for development financing
There are numerous costs to cover once you’ve secured development finance, which will vary between lenders. These can include:
Application fees: You may be charged an up-front application fee by the lender or broker for submitting the initial application.
Arrangement/Facility fees: Development finance arrangement fees are typically between 1% and 2% of the net, or gross, loan amount and are charged by the lender for setting up the loan. Lenders normally only charge their arrangement fee if the loan is drawn down.
In most cases this fee is added onto the loan facility, enabling it to be paid when the loan is repaid. Since it is added to the loan facility, interest will also be charged on the arrangement fee.
Valuation fee: A valuation will need to be carried out by a surveyor to ascertain the current Market Value of the site “As-Is”, and to provide a projected Gross Development Value; “On Completion”. As a guide the fee for a Development Appraisal will be circa 0.1% - 0.15% of the GDV.
Interest rate: The interest rate varies for each lender and is usually rolled up. Rates will typically be variable, and priced as a margin over SOFR (Secured Overnight Financing Rate), although this will also be dependent on what currency you are borrowing in. Whilst the majority of lenders will only charge interest on the funds you have received, some will also charge it on the funds you haven’t yet drawn.
Legal fees: A solicitor may need to complete the legal aspect of your loan application. In addition to paying your own fees, development lenders will require you to cover any legal costs they incur with regards to your application. Every application is different and legal fees vary depending on the facility size, location of the development, complexities of the work involved, how large the site is, how many titles, etc.
Development Coast Analysis and Drawdown Monitoring fees: You may be required to pay for the Bank to have a Development Analysis undertaken, to verify the costs being suggested for the project are sufficient to complete it.
During the course of the development, many lenders will send out surveyors to monitor the progress of the project. The costs of these visits are picked up by the Borrower as drawdown or fund monitoring fees. The amount charged for fund monitoring fees will depend on the size of the project and also the Lender.Exit Fee: Development finance loan agreements quite often include an exit fee, where there is no conversion to a mortgage at the end of the Project. Typically, a development finance facility may include a 1% exit fee.
This 1% fee is normally calculated using one of three options:
○ The net loan amount of the facility
○ The gross loan amount of the facility
○ The Gross Development Value of the project
Personal Guarantees: Because a new project has no history and a substantial amount of perceived performance risk, the equity required by the Lender may potentially include a requirement for personal guarantees from the Borrower.
The Borrower must be prepared for covenant support for the project: they need to put their names behind their money. Not many borrowers are getting unsecured financing in today’s economy. The Lenders will want the Borrower to have “skin in the game” to ensure the success of the project through the construction phase until there is a sufficient equity being committed by the borrower. Although we do expect that this will be contingent on the proportion of Capital that the borrower is able to inject into the project.
Building Your Lenders Confidence
Our first task when applying for financing for a development project is to convince a Lender that the Project is viable.
Will the Loan be repaid, through the sale of the project on-completion, if the completed property is placed on the Market.
The challenge will be that before lending out money, Lender’s are required to carefully assess the Risk of the project, based on criteria that a new or inexperienced key contractor, may have a hard time meeting. Lenders need to look at their history, at the contractor’s previous projects and at the performance of the market sector for the completed property, before deciding that a project is worth lending on.
A new project, along with a Developer or Contractors who are new to the industry makes for a riskier proposition for a Lender. Especially when compared to a seasoned contractor with numerous schemes already behind them, and a longer held relationship with the Lender.
Knowing the Risks to the Lender
Construction lending risk falls primarily into four categories: over funding, under funding, funding work that’s not complete, and funding trades that are never paid.
Over-funding - usually begins in the contract phase, when a project is overvalued, and the lender fails to catch the discrepancy. This can happen for a number of reasons, from a developer or contractor inflating the project costs to line their own pockets, to simple inexperience. Regardless of the reason, it’s a major vulnerability for the lender, because if the developer defaults, the lender may not recover the loan value with foreclosure.
Under-funding – Where insufficient funds are allocated or agreed to complete the project as specified, either due to variations being made to the design by the Borrower during the project, or unrealistic costings and build contract terms were agreed. Where a Lender is requested to extend further funds beyond those agreed under the initial loan terms, this can involve a re-application for the construction loan and incur significant time and expense to arrange.
Funding Work That’s Not Complete – Construction funding is usually provided on an as-completed basis, meaning that the contractor is authorized to request “draws” on the funds as previously agreed-upon portions of the work are completed. For instance, if the contract states that the contractor may draw 25% of the funds at 25% completion, then naturally that is when the contractor should request payment for that amount. This presents a risk for the lender in the event that a contractor is not accurate in stating the amount of work completed. When payments are made too early for work that is not complete, the project runs the risk of the contractor walking off the job, leaving the owner and, ultimately, the lender responsible for either funding the work a second time or writing the project off.
Funding Trades That Are Never Paid - With the way construction loans work, the lender very rarely interacts directly with subcontractors. Instead, the owner signs the construction loan contract, and the bank pays either the owner or the general contractor directly. The general contractor pays its expenses and profit, and then the subcontractors. In some cases, however, either because the contractor’s expenses are higher than expected or because the contractor is unscrupulous, the subcontractors never get paid. When this happens, they may have the right to file claims against the property, which becomes a liability for both the owner and the lender.
How to Mitigate Lending Risks
The primary tools for mitigating construction loan risk are the Development Analysis & Cost Review and Construction Monitoring Inspections – which would be undertaken by the Fund Monitor or Quantity Surveyor who represents the Lender. The Fund Monitor needs to act as the Lender's
”Eyes & Ears” on the development project.
The Development Analysis and Cost Review represents the beginning of the risk mitigation process. This review ensures that all of the contract documents are coordinated in line with the requested loan amount and the lender’s expectations.
The Construction Budget
In a new construction, where the project is of a sufficient size, there is an advantage to developers and key contractors who have been building a while and have a number of projects under their belts, as they will have a foundation on which to base their costings.
Newcomers just getting into a Market will often need to hire local third-party advisors, such as a Quantity Surveyor or Project Manager, in order to get confident enough to go forward on a project, and to ensure their budgeted costs are realistic, contracts are prepared correctly, and the budgeted costs are sufficient to complete the project up to specification.
Not surprisingly, in a construction loan, a key focus of the project underwriting will be on the construction costs and the Contractor’s ability to perform. The Lender will carefully review the plans and specifications for the project, often relying on a third-party expert, such as a Quantity Surveyor, Project, or Fund Monitor.
Cost estimates will be reviewed, especially if a construction contract hasnot yet been executed. If a construction contract is in place, it will obviously be helpful if it is on a stipulated sum or guaranteed maximum price basis.
An effective Development Analysis and Cost Review focuses on the Three C’s:
Cost, Constructability, and Contingencies.
Costs should be appropriate for the job, and in line with current market conditions, down to the line item. Likewise, the drawdown schedule or milestones should be appropriate to the timeline, accounting for the order and pace at which each trade will complete their work.
Constructability ensures that the project can be completed as contracted for, with the appropriate infrastructure, and materials and to the finish specified
Contingency review ensures that an appropriate amount is designated to cover any surprises that arise during the construction phase.
Lenders know that Contractors and Borrowers alike may attempt front-end-load the hard and soft costs of a project. The contract price and fees will be evaluated and benchmarked, especially if the Developer and Main Contractor are affiliated with each other.
An adequate retention, as a percentage (often 5%) of the amount certified as due to the contractor on an interim drawdown certificate, is expected to be deducted from the amount due and retained by the Client.
The purpose of retention is to ensure that the Contractor properly completes the activities required of them under the contract. Any below-market arrangements will be scrutinised carefully. Similarly, the lender will pay careful attention to both the Contractor’s and the Borrower's contingencies. During the Loan’s underwriting stage, the Contractor should be prepared to help the Developer address issues related to the contractor:
Is the Contractor bonded or bondable, or does it have access to a meaningful corporate or parent guarantee?
Within a busy island market, might the Contractor be stretched too thin?
What other projects will it have under way at the same time?
How much recent experience does the Contractor have with this specific type of project?
And what is the particular experience of the Contractor team being proposed for this type of project?
If a Contractor is to serve its Client well, then they should not only be prepared to answer these questions; it should actively assist their Client in preparing an appropriate package of information that anticipates these Lender concerns. Other areas in which the Contractor can assist their Developer Client in supporting the loan application include:
Preparation of construction budgets, bill of quantities and cash flow projections
Construction schedule, project timeline and key milestones
Qualifications and regime of experience of key participants
Selecting the most appropriate project delivery method
Establishing a reasonable Guaranteed Maximum Price (GMP) at an early stage in design
Feasibility and constructability reviews
Value engineering
Demonstrating ability, or track record, to work with the design professionals involved in the project
Controlling Your Costs - Lenders Looking Over Your Shoulder
Typically, a Lender will require roughly 25% equity to be put into a project, before they will start to disperse a construction loan. The initial investment from the developer can include the current Market Value of the land. Once the Developer has provided an acceptable budget, or construction contract, with costs comparable to industry standards, the lender will advance money based on an analysis of costs in place and the cost to complete the project.
The lender distributes the money in stages so that he or she doesn’t end up in a position where they are forced to either put more money into the building than previously negotiated or be left with an incomplete building. These Drawdowns are often reviewed by a Quantity Surveyor, Fund, or Project Monitor. This professional oversees the project and advances money on a schedule after satisfying themselves that the costs in place are occurring according to that schedule.
Along with documenting the progress of the Project, the Drawdown Report will address two major concerns: Timeliness of payment and Change Order review.
Timeliness of payment involves inspecting the project to ensure the agreed-upon work has been completed prior to draw approval. Once payment has been made, the timeliness of payment review confirms that all subcontractors are paid in accordance with their agreements.
Change order reviews occur whenever the contractor requests additional funds to cover a change order. They ensure that these requests line up with current real time material and labour costs.
It is at this stage where projects often run into difficulty. If construction costs get out of control, the Developer will be expected to inject any additional funds to cover them, and not the Lender.
The Importance of Practical Completion
As suggested in RIBA Plan-of-Work 2013:
“Practical Completion is a contractual term used in the Building Contract to signify the date on which a project is handed over to the client. The date triggers a number of contractual mechanisms.”
Practical completion is referred to as 'substantial completion' on some forms of contract, particularly in the United States. The certification of Practical Completion once all the works described in the contract have been carried out.
This certifying practical completion has the effect of:
Releasing half of the retention (an amount retained from payments due to the contractor to ensure they complete the works).
Ending the contractor's liability for liquidated damages (damages that become payable to the client in the event that there is a breach of contract by the contractor ‐ generally by failing to complete the works by the completion date).
Signifying the beginning of the defect’s liability period.
Once the certificate of practical completion has been issued, the client takes possession of the works for occupation. It is important to note however, that the defects liability period, which follows certification of practical completion, is not a chance to correct problems apparent at practical completion, it is the period during which the contractor may be recalled to rectify defects which appear following practical completion. If there are defects apparent before practical completion, then these should be rectified before a certificate of practical completion is issued.
Development Finance in Summary
A Construction Loan is a short‐term loan, usually three years or less, obtained by a borrower to finance the construction of real property. This can be structured around a real estate transaction, ‐where this is also known as a building loan, development loan or a construction mortgage and is secured by a mortgage on the real property to be developed.
The Lender disburses the construction loan funds through drawdown payments over the construction period, as certified by the Fund Monitor, as the different phases of the construction project are completed and the borrower has met certain conditions precedent.
A real estate construction loan generally is either:
Satisfied, when the project is completed and permanent financing is obtained to payoff the construction Lender; or
A combination loan that is a construction loan in the beginning and then becomes a permanent loan or mortgage when the project is completed.
