Construction Lending in Recessionary Times: The Economic Downturn Has Caused Banks to Take a Second Look at Their Construction Loan Portfolio and Practices

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THE ECONOMIC DOWNTURN has created a tremendous strain on construction and real estate lending, posing significant risks and challenges for banks. Participants in a recent RMA audioconference on construction lending identified four questions banks need to address:

1. What's to be done with existing projects and how can the bleeding be stopped?

2. How can the underwriting phase be improved?

3. What are the practical aspects of construction loan administration: training, subcontracting, control?

4. What are the problem areas or red flags?

How to Stop the Bleeding

Vaughn Pearson, a former chief lending officer and chief credit officer with 25 years of experience at Dallas-area banks and an RMA instructor for more than 30 years, says lenders need to go beyond thinking outside the box. "I would say throw away the box because you're going to have to be very inventive and creative. Ultimate solutions to problems typically are not obvious."

Pearson recalled a loan made more than 20 years ago for a 40-story downtown building in Dallas. "It became very obvious early on while the underground parking garage was being constructed that the project simply wasn't going to work. The demand for office space had evaporated.

"So a strategic decision was made by the bank involved, in concert with the borrower, to stop construction once the underground parking garage was completed. It is a fully functioning parking garage to this day. There is no building on the site."

Depending on how far along a project is, deciding jointly with the developer not to continue may be the wisest option for a development loan in trouble, said Frank DiLorenzo, a commercial real estate credit officer with SunTrust Bank in Miami. In Florida, ground zero for troubled real estate, DiLorenzo worked on projects where developers' leasing expectations were not met. After approaching the developer with the unadorned market facts, SunTrust obtained a joint agreement with the developer to not proceed with the planned construction.

"Be flexible," advised Henry Claussen, vice president of loan administration at the Bank of Stockton in Stockton, California. "Rigid adherence to inflexible policy can come back and bite you. Be flexible with loan-to-value and debt service coverage. In a workout situation, you have to be creative. One solution our California bank implemented was lending to the developer who leased the property with an option to buy," he said.

"Dealing with the subcontractors can also be ticklish," Claussen added, although in California he finds this to be less the case. "Even if the subcontractors have lien rights, there's virtually nothing to collect on. As long as you pay them something, maybe not 100% on the dollar, they're usually willing to deal with you and allow a workout to continue." For Larry Helm, a financial consultant and RMA faculty member who has worked on the construction and lending sides of the table, a bank's quick reaction to a problem is critical to stop the bleeding. "Identify as many interested parties as possible as early as you can, including partners and subcontractors. Get in first and latch on to the collateral before the equity evaporates."

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Helm and others noted that in the downturn, particularly with residential construction, past behavior of customers is not necessarily a good indicator of how they'll respond now.

"In the past, we relied heavily on the relationships we had with borrowers, but we've run into an unusual time where even good people have problems," he said. "We can't just rely on past performance. There has to be empirical evidence."

How to Improve the Underwriting Phase

If a deal looks bad during the underwriting process, a bank should step away from the loan.

"Many times there are things that could have been flushed out in the underwriting process," said Richard Hamm, another RMA faculty member, consultant, and author of RMA's course, "Construction Loan Management. …