Forensic, General & Medical
Expert Witnesses

Construction Lending Industry Standard Practices Applicable to Construction Loan Litigation


     By Don Coker Banking Consultant & Banking Industry Standard Procedures, et al., Expert Witness

PhoneCall Banking Consultant & Expert Witness Don Coker at (770) 852-2286


Expert Witness: Don Coker
The author, and experienced lender and expert witness, explains the industry standard process of how construction loans and acquisition and development loans are originated and administered.
How Construction Loans are Made

Construction loans are short-term loans that are funded in increments as the development’s construction progresses. The borrower pays interest only on the outstanding balance, so interest charges grow as the loan ages. The construction loan is repaid in full – by a permanent or intermediate-term loan – at some specified time shortly after the completion of construction.
In the case of a typical $1 million-plus property, construction time is usually between nine and twenty-one months. Therefore, construction loans usually run for a term of twelve to twenty-four months, allowing a few months’ cushion for unforeseen problems such as weather, materials delivery delays, labor problems, etc. Construction loan maturities are often as much as a year or more longer than the construction period in order to allow some time for leasing.

How Construction Loans Are Used

A construction loan is granted to fund all or part of the costs required to build and otherwise develop a new development.

From a lender’s perspective, a construction loan is a short-term, high-risk, high-yielding investment. To help mitigate this risk, construction lenders follow strict procedures to insure that there is a reasonable relationship between their outstanding loan balance and the value of their collateral. They usually also require the construction loan borrower to provide, in advance, a takeout commitment issued by another lender. It states that a loan for a certain (or sometimes a variable) amount will be funded by the takeout lender by a certain date after the construction is completed. Naturally, the construction lender wants to insure that the completed development will meet all of the requirements of the takeout commitment which will eventually repay the construction loan.

Lending Parameters and Guidelines

Listed below are general guidelines followed by all construction lenders – although each individual lender tempers them to fit its own regulatory and internal policies and guidelines:

1. Loan-to-Cost Relationship. The maximum amount a construction lender will lend is the amount of the takeout commitment that will eventually provide their payoff. Furthermore, construction lenders are reluctant to lend more than 75% to 80% of the appraised value of the completed development. This coincided with typical takeout loan parameters, and often allows the developer to borrow 100% of costs. In fact, many construction lenders make it their standard practice to lend up to 100% of costs – which used to be the industry standard.

In recent years, however, construction lenders have become increasingly concerned about 100% financing, and often require that a borrower contribute at least a minimum amount of cash equity into the development. This equity must go in at closing, or in the early stages of the loan. The equity requirement helps to weed-out marginal deals, and helps insure that the borrower will be more attentive to this lender’s loan, as opposed to another loan in which the borrower has no cash equity investment.

2. Bonding Requirements. Construction loans usually require performance and payment bonds for their loans. A performance bond guarantees that the construction contract will be performed as stated, so that the development will be completed in conformance with the plans and specifications. In theory, if the general contractor should step out of the picture for some reason, the writer of the performance bond – referred to as the surety, and usually an insurance company – would hire another general contractor to complete the work.

A payment bond is similar except that it guarantees payment for all materials and labor.

These two types of bonds are written for the amount of the general contract, and are usually required in tandem. Also, the construction lender usually requires a dual oblige rider to the bonds, which makes the lender an obligee in addition to the borrower. This gives the lender a much stronger voice in the negotiations should the general contractor default necessitating that the bonds be used.

3. Takeout Commitment Letter. As a binding guarantee of their eventual payoff, the construction lender requires a copy of the permanent lender’s commitment letter. This letter will recite the terms of the permanent loan being offered, and the conditions under which they will fund the loan.

Of the utmost importance to the construction lender are the conditions recited in the commitment letter, especially any that would be difficult to meet, thus relieving the takeout lender’s obligation to fund. For example, the takeout commitment will state a certain window of time, or possibly a specific time, during which the takeout loan will be funded – thus requiring that construction be completed by a certain date. If the construction lender is of the opinion that the development cannot be completed by the specified date, then it will not accept the commitment.

Furthermore, the takeout lender will approve detailed plans and specifications for the development prior to issuing their commitment letter. Then during and after construction, they will inspect the development to insure that what is actually being built conforms to the previously approved plans and specifications. Generally, takeout lenders are not obligated to immediately notify the construction lender if they discover that the development is not being built in conformance with the plans and specifications, but it is advantageous for all parties to seek such an agreement. A variance from the plans and specifications could relieve the takeout lender’s obligation to fund.

The takeout lender will require an appraisal at some point in the process of committing and closing a loan. The appraisal may be performed either by an outside appraiser selected or approved by the takeout lender, or it may be performed by a member of the takeout lender’s staff. Sometimes, takeout commitments will state a specific loan amount, and will also require an appraisal of the property – funding only 75% (or whatever loan-to-value ratio they have approved) of the appraised value. This, of course, is unnerving for the construction lender since the takeout amount is actually an unknown.

A few takeout lenders will issue commitments that state they will only fund if a certain percentage of the development is leased by a certain time. Otherwise, the commitment is null and void. This is really no commitment at all, and is unbankable, i.e., a bank or other construction lender will not use such a takeout as a basis for lending construction funds. For the takeout commitment to be bankable, it must state that the lender will fund some amount by some date, and not contain any “kiss your elbow”-type requirements.

What Construction Loans Cost

Charges for construction loans are stated as a fee – the construction loan fee – and an interest rate. The construction loan fee is computed as a percentage of the construction loan amount – most commonly 1%. A fee of 1% is commonly called one point or simply a point. To further ad to the confusion, you should know that 1% is equal to 100 basis points. So if a lender says 25 basis points, it means ¼ of 1%.

Points greatly increase the construction lender’s yield on its investment since the entire fee is paid at closing, but only a small portion of the loan is disbursed then. As an example, consider a twelve-month construction loan of $1,000,000 with a 1% construction loan fee of $10,000. For simplicity’s sake, let’s assume that the loan proceeds are disbursed evenly over the twelve-month period, so that the average outstanding balance id $500,000. Thus, the construction lender’s fee – 1% of the loan amount – is actually divided by the average outstanding balance or lender’s average investment of one-half of the total loan amount, and is equivalent to an actual return of 2%. If the loan is repaid prior to maturity so that the funds are outstanding for an even shorter period, then the lender’s rate of return is even higher.

Interest rates on construction loans are higher than interest rates on permanent loans for two reasons. First, there is inherently more risk in a construction loan than in other types of real estate loans. This risk is in the form of construction risk, i.e., the risk that there could be a problem during construction. More specifically, if the construction lender has to foreclose during construction, it not only has the problem of disposing of the property – the illiquidity problem always associated with real estate – but it must first take whatever steps are necessary to complete the construction. This could be anything from simply calling on the payment and performance bond sureties, to suing the sureties, or hiring a contractor. The alternative is to attempt to sell a partially built development, which is practically impossible.

Second, by making the interest rate on the construction loan higher than the interest rate on the permanent loan, the lenders are creating an economic incentive for the developer to complete the construction on a timely basis and close into the permanent loan as soon as possible. This helps the construction lender recover its funds as quickly as possible – thus helping its yield, and enabling an early reinvestment of the funds. It also helps insure that the permanent lender will be able to maintain its funding schedule for investment management purposes.

Since construction loans are a short-term investment for a financial institution, interest rates are typically keyed to fluctuate at some premium above the prime commercial loan rate, and are adjusted up or down monthly as the prime rate fluctuates.

The interest rate may also fluctuate over some other rate that more closely relates to the lender’s source of funds, such as the commercial paper rate.

How far the construction loan interest rate floats above the prime rate, or other base rate, is a function of the lender’s competitiveness, the strength of the developer, the acceptability of the takeout commitment, and the economy in general. In short, it reflects the lender’s assessment of all of the risk factors in the loan. However, construction loan interest rates usually range from ½ of 1% over prime, to 3% over prime.

When the real estate and financial markets are strong and lenders are competing for good loans, some lenders will entertain fixed-rate construction loans. These are not as common as they used to be, but they are sometimes available.

Each month during the term of the construction loan, the adjusted interest rate is applied to the outstanding loan balance for that month to arrive at the month’s interest charge. Then either the borrower is billed – if interest is being paid out-of-pocket by the borrower – or an accounting adjustment is made by the lender to pay the month’s interest charge out of the loan’s interest reserve, if one has been structured.

How Interest Reserves are Calculated and Used

An interest reserve fund is usually included in the construction loan amount. This practice relieves the borrower’s monthly obligation to come up with the interest payment – at least until all of the funds in the interest reserve have been used. The reserve may be structured to cover all or only part of the anticipated interest charges, depending upon the lender’s parameters.

Lenders have two lines of reasoning regarding interest reserves. First, lenders who dislike interest reserves feel that the borrower’s requirement to make monthly interest payments serves as an added incentive to insure a timely completion of construction and payoff. And indeed it does. Second, assuming that the takeout commitment upon which the construction lender is relying for its payoff includes all of the costs, then the construction lender knows that by disbursing the full loan amount – including the full interest reserve – the development can be completed, thus justifying the funding of the takeout loan which will fully pay off the construction loan. If there is no interest reserve, there is more of a risk that in the case of a default, the construction lender could have to fund the entire construction loan plus absorb the interest charges. This total amount could exceed the takeout loan amount. Of course, a prolonged construction period or an interest rate higher than projected can cause an overrun in the interest budget, regardless of the manner in which the interest is paid.

Methods Used to Estimate the Amount of Interest

There are only two methods used to estimate the amount of interest that will be paid over the term of the construction loan: (1) The way most borrowers and lenders do it, and (2) The right way.

In method (1), the computations are quick and easy, and can even usually be calculated mentally. As an example, consider a twelve-month construction loan of $1,000,000 with an average interest rate of 15%. All you do is assume that one-half of the loan amount is the average outstanding balance, and then multiply that amount ($500,000) times the interest rate (15%) and voila: the interest amount is $75,000.

If you want to get fancy, try the same example but with an eighteen-month term. If you project that the development will be completed within twelve months, then proceed as you did above and simply calculate an additional six months’ interest on the fully disbursed amount. (Technically, of course, you would have to compensate for the interest reserve being disbursed over the final six months, but people that use this method do not concern themselves with that.) In our example, this comes to another $75,000 ($500,000 X 15% X 1 year = $75,000, plus $1,000,000 X 15% X .5 years = $75,000) for a total interest amount of $150,000.

Method (2) is the accurate method for estimating the total interest amount. In this method, you must make up a month-by-month estimate of the funds to be disbursed – from the closing through the maturity date of the loan. Then the interest amount is laboriously computed on the outstanding balance each month. The grand total of these monthly interest amounts is, of course, the best estimate of the total amount of interest. We all know that it is impossible for a development to proceed exactly as planned in a month-by-month budget as described above, but nevertheless, this method will yield a usable number that is hard to dispute, and it will add a high degree of professionalism to your loan package or analysis.

Actual Example: How the Methods for Estimating Amounts of Interest Vary Significantly

This real-life example demonstrates how the estimated interest expense amounts derived by using the two methods can vary significantly:

The Oil Town Apartments’ estimated construction cost budget for all hard and soft costs items, except interest, totals $9,623,250. The construction loan matures in twelve months, and the interest rate is projected to average 18%. The construction loan interest amount estimated by the short-cut method totals $866,093 ($9,623,250 ÷ 2 = $4,811,625 X 18% = $866,093). Yet an actual month-by-month computation applying the projected interest rate against the projected outstanding balance for each month indicates an actual construction loan interest total of $1,012,100 – a difference of $146,007 and a variance of 14% from the short-cut method estimated amount. Even though this example does not define the limits of the possible error, when you consider that the variance could just have been a minus 14% as a plus 14%, you can see that you could easily have an error range that could cause serious problems.

For instance, if an interest reserve is used in the construction loan, the borrower would be called upon to fund any interest expense over and above the reserve amount, and this could cause serious financial problems. And if the error had gone the other way, i.e., if the interest amount were overstated, then the borrower might obtain a larger loan than needed, and thus pay more fees than necessary.

How Construction Draws Work

Construction loans are always funded in increments by a series of payments called advances or draws – usually monthly – so that the amount of the loan actually outstanding bears a logical relationship to the value of the work in place. Basically, the construction lender must be sure that the current value of the land and improvements exceeds the outstanding loan balance by a comfortable margin.

Stored Materials

Stored materials can usually be included in the draw request for the period in which they were purchased and delivered. You should check your construction lender’s policy on this matter before making any significant commitments for materials to be used in future months, since some lenders will not fund for this purpose. Sometimes these materials – especially the more universally usable ones such as drywall, reinforcement steel, etc. – have a tendency to “walk away” and find their way to another job. Also, a larger cache of materials stored on the site is a much more likely target for theft.

Change Orders

On virtually every construction job, the developer finds it necessary to make at least a few changes as the work progresses. The changes may be modifications, additions, or deletions to the original plans and specifications. When the need for these changes becomes evident, the developer and contractor execute a document called a change order which states the nature of the change, the dollar amount of the change, and any additional time allowance. This document becomes a supplement to the existing general contract.

Often overlooked is the fact that both construction and permanent lenders have committed to lend based upon the plans and specifications they were presented and approved. Accordingly, both lenders should be apprised in advance as to any contemplated change orders. Furthermore, since payment and performance bonds are keyed to the plans and specifications and the general contract, it is likewise prudent to inform the surety(s) of any proposed changes.

Three Methods of Paying Construction Draws

The three methods used to pay construction draws are:

1. Monthly Advance Method.
This is the most common method for paying construction advances for income property loans. Each month, the borrower presents the lender with a list of the construction expenditures for the month just ended. This list includes all payments to the contractor or contractors, payments for other labor, and payments for materials as well as payments for soft cost items such as architectural fees, legal fees, and permits. In other words, these include all expenditures related to the construction and included in the original cost estimate approved when the loan was closed. The construction lender then advances funds to the borrower as reimbursement for these expenditures.

2. Stage Payment Method.
This method specifies that certain amounts will be disbursed when certain work items are completed. Single-family housing construction loans are quite commonly disbursed via this method since they are somewhat similar in their general proportions and lend themselves to a “cookie cutter” approach.
This method is not as common among income property loans due to their diversity and uniqueness, but it is sometimes employed on a limited basis. For example, the construction lender may fund $X when the slab is in, $Y when the walls are up, etc.

3. Cost-To-Completion Method.
Under this method, the remaining cost to complete the development is estimated before each advance is paid. Thus, the lender assures itself that the amount of undisbursed loan funds remaining after the current advance will be sufficient to complete the construction of the development. If an unfavorable variation in the costs indicates a future shortfall, then the lender will fund less than the developer’s actual expenditures for the month, and the developer must then fund the short-fall amount prior to the lender advancing the draw funds. The cost-to-completion may be used in conjunction with either of the other two draw methods as an extra safety factor.

The Mechanics of Paying Construction Draws

In order to insure timely payment of construction draws, the borrower should have a clear understanding of the lender’s draw procedures and requirements. The delayed payment of a draw can set in motion a domino line of problems that can potentially result in a temporary halt in construction.

Construction work is like mixing cement: Just as you would not think of letting the cement sit for any length of time, you likewise do not want to see any slow-down or temporary halt in construction work once the job has commenced. Since contractors and subcontractors are paid incrementally – usually monthly – for the work they have completed, it is not an overwhelming burden for them to move to another job where they can expect timely payment. This leaves the developer to seek possibly a legal remedy, which does not help get the building built. If this happens, the end may be near. The developer, the development, and even the lender have to put on the “albatross necklace.”

What A Draw Request Should Contain: A Checklist

Construction lenders typically use American Institute of Architects ("AIA") forms G-702 and G-703 to document each draw request. G-702 is a summary form and G-703 is the detail that supports the summary.

When a draw request is received by a lender, it is checked for completeness of the data and for justification of the dollar amount requested. Standards vary among lenders, but the follow items – in one form or another – must be included in each draw request:

● Narrative report of the job’s progress since the last draw. This should also mention any problems or delays encountered, and should explain any change orders. Pictures are helpful.

● Summary of monies spent since the last draw. This should be listed by line item, so as to conform to the lender’s detailed cost breakdown. Usually the lender’s draw forms will have a column for the cumulative total for each item. This facilitates a quick cost-to-completion analysis. Back-up invoices and proof of payment should be included for each of the current items.

● Title update. This item is optional depending upon the laws of your state and the practices of the construction lender. When a title update is required, the borrower must each month have its title company provide the construction lender with formal assurance that no additional liens have been filed against the property. This indicates to the construction lender that the subcontractors and material men are being paid by the contractor. This assurance to the construction lender may be in the form of a “nothing further certificate” or a formal endorsement to the previously issued title policy.

● Inspector’s report. After the draw request reaches the construction lender, a member of the construction lender’s staff will make an on-site inspection of the property to confirm that all work items and materials included in the draw request are, in fact, in place. For this reason, it is a good idea to notify the inspector a couple of days prior to submitting your draw that it is in the hopper, so the inspector can begin to arrange a schedule. This is especially important if the inspector must come from out of town.
Sometimes an outside, independent inspector is hired (paid for by the borrower, of course). The borrower is directed to forward the completed draw request to the inspector who then makes the inspection and submits a written report along with the draw request to the construction lender.

How the Money Comes and Goes

Once the construction lender has approved the draw request, there are several methods used to forward the funds. The construction lender will agree when committing and setting up the loan exactly how funds transfers are to take place. The funds may be transferred to any of the following parties:

● Borrower, who in turn pays the general contractor, or subcontractors, and possibly the material men.
● General contractor, who in turn pays the subcontractors and material men.
● Subcontractors and material men may be paid directly by the construction lender.

Also, there are several methods of advancing the funds:

● Checks or drafts on the construction lender’s bank account sent to the borrower, general contractor, subcontractors, material men, etc.
● Wire transfer of funds from the construction lender’s bank account, or to a special bank account created just for the development.
● Two-signature checking account specifically for the construction job, where the borrower and lender must both sign the checks. The borrower makes out the checks, signs them, and forwards them to the construction lender with the draw request. Once the draw request is approved, the lender signs the checks, sends them out to the various parties to be paid, and simultaneously wire transfers the proper amount of funds into the job’s checking account.

How Retainage Works

Construction lenders usually hold back (or retain) 10% of each draw. This retainage serves several purposes. First, it is sometimes required by state law as a precaution against a borrower or general contractor who has received construction advance funds, but fails to properly pay the subcontractors, material men, or others, thus inviting the filing of a mechanic’s lien against the property.

Second, general contractors often hold back retainage on their subcontractors, so the construction lender wants to make sure that it is not disbursing any more than the general contractor is disbursing.

Third, retainage provides the construction lender with some degree of protection – a sort of contingency fund – which can be used to help clear up any mechanic’s or materialmen’s liens that might have been filed against the property during construction.

So then after the job is 100% complete, the construction lender is still holding 10% of the loan amount. This retainage is held for a specified period of time – usually coinciding with the state’s limit for the filing of mechanic’s and materialmen’s liens – and then disbursed in a lump sum to the party that has been receiving the construction loan advances.

Planning tip for covering possible shortfalls due to retainage: In any case where a lender is holding back retainage, the borrower and general contractor, or both, must include in their cash flow projections self-funding to cover any shortfalls between their inflow of construction loan funds and their outflow of payments to subcontractors, material men, etc.

How to Handle Holdback Provisions

There are two types of holdbacks encountered in construction loans: (1) Economic holdbacks, and (2) Tenant finish holdbacks.

1. Economic Holdbacks
If the proposed development involves a large amount of speculative leasing, such as an apartment development or an office building, then the permanent loan takeout commitment will often state that the permanent lender will only be obligated to fund a floor or base amount – usually 75% to 80% of the full loan amount – until some specified level of leasing performance is achieved. This leasing level is usually around the pro forma break even level for the development. This will be covered in more detail in the latter part of this chapter, but let it suffice here to say that the construction lender often will not fund any more than the takeout lender’s floor or base amount unless the construction lender is assured that the takeout lender’s requirements for full funding have been met. Otherwise, the borrower must provide a gap loan commitment, or cover the difference in the two amounts via a letter-of-credit, other collateral, etc.

How a Gap Loan Commitment Works

A gap loam commitment is a short-term commitment – usually running concurrently with the construction loan’s term or the rental achievement period – to fund the difference between the base amount of the takeout commitment and the full construction loan amount. Thus, if the development fails to achieve the full funding of the takeout loan, then the construction lender is still assured of a full payoff with the difference coming from the gap loan.

Example: Payno Claims Life Insurance Company has issued a commitment to make a $2,000,000 thirty-year loan for the proposed Barracks House Apartments. The construction time is estimated to be fourteen months. Some units should be completed and ready for occupancy during the sixth or seventh month. In order to fund the entire $2,000,000 Payno is requiring that the apartments must be generating gross rental revenues of at least $XXX,XXX from no more than 80% of the units – which is equivalent to 80% occupancy at the proforma level. If the apartments are not achieving this level when the construction loan matures, then Payno Claims Life Insurance Company will fund only 80% of the total loan – or $1,600,000.

Scenic Check National Bank has agreed to make a $2,000,000 eighteen-month construction loan for the Barracks House Apartments. To assure its full payoff in case the permanent loan takeout commitment’s rental achievement is not met, it is requiring the developer to provide a gap loan equipment from Toaster Credit Company for the $400,000 potential shortfall. Then if the rental achievement has not been met by the specified time, Scenic Check National Bank’s construction loan would be paid off in full by $1,600,000 from Payno Claims Life Insurance Company and $400,000 from Toaster Credit Company.

A gap loan, when funded, if a very short-term loan – usually less than five years. Interest rates are very high – usually 3% to 6% above the commercial bank prime interest rate. They may or may not include any amortization, which is not really too meaningful in light of their extremely short term. Often, they are interest-only, with the full principal amount due in a balloon payment upon maturity.

Gap Loan Fees

Commitment fees, or gap loan fees, are where the gap lender expects to make its money. They are based upon the dollar amount of the gap loan commitment, and the time period over which the commitment will be outstanding. A general range is 2% to 4% per year; so in the example cited above, the developer would have to pay 2% (Let’s take it easy on him in this example.) X $400,000 X 1.5 years = $12,000. Toaster Credit Company earns this fee for writing the gap loan commitment whether or not it has to fund any money. If the development fulfills the rental achievement requirements of the permanent takeout commitment, then the permanent lender pays off the construction lender in full, and the gap lender’s involvement ceases.

A note of caution: Always make sure that the intended gap lender is acceptable to the construction lender. Some gap lenders are like children at the ice cream counter who sometimes find out later that their eyes are larger than their stomachs. Gap lenders project their anticipated fundings by assuming that they will be called on to fund X% of their outstanding commitments. If their actual level of fundings is above X%, then the gap lender must obtain additional funds – if available – or else fail to honor a portion of its commitments. In the later case, the construction lender will then receive only a partial payoff, which creates problems of all sizes and shapes. If this happened, the probable result would be that the permanent lender would fund the base amount to the construction lender and receive a first lien. The construction lender would then be forced to take back a second lien for the shortfall, or gap, amount – a real messy situation for everyone.

Letter-of-Credit: An Alternative to a Gap Loan Commitment

As an alternative to a gap loan commitment, construction lenders will usually accept a letter-of-credit for the difference in the two loan amounts. Again, the same caveat applies here regarding prior approval of the proposed letter-of-credit writer by your construction lender.

A letter-of-credit is a commitment usually issued by a commercial bank stating that the named party – in this case, the construction lender – may call upon the bank to fund all or part of the credit line stated in the letter-of-credit during the time period that the letter-of-credit is in effect.

Example: If construction lender Scenic Check National Bank held a letter-of-credit for $400,000 from the Hoard National Bank, and if it were valid during the maturity of the Barracks House construction loan, then Scenic Check National Bank could use the letter-of-credit funds to pay off their balance remaining after the Payno Claims Life Insurance Company funded their base amount.

In other instances, especially where the construction lender has an extremely high opinion of the borrower and the development, the construction lender may elect to fund through the gap, i.e., shoot the gap, and fund the full loan amount – including the gap portion – without requiring a gap loan commitment, letter-of-credit, etc. When a construction lender does this, it is confident that the development will meet the takeout commitment’s rental achievement without any problem, or that the borrower can cover the gap portion from his own funds if the achievement is not met.

2. Tenant Finish Holdbacks

In an office building or shopping center development, there is a fund of money included in the construction budget to finish out the tenants’ space after it is leased. These funds are advanced as the work if completed, just like the rest of the items in the construction budget. Tenants in the development are allowed a standard finish package, such as the one cited below, for an office building:

Per 1,000 Square Feet of Net Rentable Area

81 linear feet of wall
3.5 doors
4 electrical switches
9 electrical outlets
4 telephone connections
$XX per square yard for carpeting

From the tenant finish allowance – also called a build-out allowance – the tenant should be able to design a standard office. If the tenant requires more than the allowance standards specify, then it must pay the difference to the owner.

For example, suppose that a new tenant under the above-cited tenant finish allowance package finds that its particular needs dictate 270 linear feet of wall for a lease space containing 3,000 square feet of net rentable area. The allowance is 81 linear feet per 1,000 square feet of net rentable area, or 243 linear feet for this tenant. Accordingly, the tenant must pay the owner for the extra 27 linear feet of wall. The construction loan will only provide for reimbursement up to the allowance amount.

Likewise, if the tenant wants a higher grade of carpeting that is called for in the tenant finish allowance, then the tenant must pay the difference to the owner.

How Tripartite Agreements Work to the Advantage of Both Borrowers and Lenders

A tripartite agreement – also called a tri-party agreement or a buy-sell agreement – is a loan document signed by the borrower, the construction lender, and the permanent lender. In signing it, they all agree that at the proper time, the loan will be delivered from the construction lender to the permanent lender. Thus, the lenders can be more confident in their timing and flow-of-funds projections; and the borrower can be assured of a timely transfer from the construction loan to permanent loan status, and the concomitant interest rate reduction.

Sometimes, only one set of loan documents will be drawn to serve the needs of both the construction and permanent lenders. When the time comes to move from the construction loan to the permanent loan, the permanent lender funds the required amount to the construction lender who then assigns its first lien position to the permanent lender. This saves the time and expense of a second set of loan documents and a second closing.

In other instances, there is a second closing for the permanent loan. This enables each lender to tailor its standard loan forms to meet more precisely the needs of each deal. There is more expense to the borrower in having a second closing and a second set of loan documents, but this is the usual pattern.

Payoff Methods

Upon maturity of the construction loan, or whenever the permanent lender has agreed to fund, the permanent lender forwards the loan funds to the construction lender. To evidence the complete satisfaction of the debt, the construction lender then issues a release of lien on the property which, in turn, clears the way for the permanent lender to obtain a first lien position. Sometimes an alternate method is used in which the construction lender simply assigns its first lien position to the permanent lender when the loan funds are received.

It does not matter to the borrower which method is used. However, if a release of lien is issued – as is usually the case – then the borrower should follow through to see that it is properly recorded in the county records.

How Participations Work

A construction lender will sometimes share a part of a construction loan with another lender, or lenders, by offering what is called a participation in the loan. This means that the lead lender, i.e., the lender who originates and administers the loan, will actually sell of a part of the loan to another lender.

Lenders have several reasons for participating out loans: First, it can greatly increase their yield. The participants may receive the same rate of interest on their investment as the lead lender who is offering the participation, but they usually do not receive any of the construction loan fee paid by the borrower.

As an example, consider a construction lender who makes a $1,000,000 twelve-month construction loan with a 1% fee in addition to an interest rate floating over the prime rate. If the lender chooses to participate out 90% of the loan to other lenders and retains all of the 1% or $10,000 construction loan fee, then it will actually only disburse $100,000 – its 10% share of the loan – but will receive in addition to its floating interest rate, the equivalent of 20% on its actual cash investment (if you eyeball that the average outstanding balance will be approximately one-half of the lead lender’s $100,000 share of the loan). In other words, the lead lender receives a $10,000 construction loan fee, and its average outstanding balance is approximately $50,000 (1/2 of the $100,000) which is a yield of 20% on the fee alone.

Generally, the lead lender retains at least 10% of the loan and handles all disbursements, inspections, documentation, and other administrative matters. Plus, many lenders will offer participations at an interest rate lower than the actual face rate on the loan, thus making a spread on the rates in addition to the extra income from retaining the entire construction loan fee. Of course, all kinds of variations are structured to meet the lenders’ needs.

Second, a lender may be up to its legal loan limit with a borrower, thus requiring that it limit further loans to that borrower until some substantial paybacks are made. The lender, of course, desires to continue servicing the borrower’s needs and wants to avoid the possibility of the borrower going elsewhere for its loans. So the lender’s only real alternatives are to participate out some portion of what they already have loaned to the borrower in order to make room for the new loan request, or to originate the new loan and participate out a portion of it. Similarly, a lender may be approaching its legal limit for real estate loans of that type, in which case it would need to participate out any new real estate loans it makes.

Third, a lender may wish to fulfill obligations to other allied or affiliated institutions that rely upon it to help meet their investment needs. This includes the case where one bank in a multi-bank holding company originates a construction loan and participates it out among the other banks in the holding company, or where a bank wishes to help out some of its correspondent banks.

Other institutions are interested in buying construction loan participations for several reasons:

1. They may not be large enough to attract of fund the quality of loans they desire,

2. They may not be large enough to maintain a full-time construction lending staff,

3. They may not be able to achieve competitive yields elsewhere, or

4. They may feel that the participation being offered is a better lending opportunity than they have been offered directly.

When a participation is sold, the lender buying the participation receives a participation agreement or a certificate of participation. Additionally, the participant may receive copies of the loan documents which are being held by the lead lender.

There is no significant impact on the borrower if its loan is participated out. In fact, many times a borrower is never aware that the loan has been participated. This is because the lead lender represents the interests of the other participating lenders, and makes administrative decisions about the loan on their behalf. However, if the lead lender goes crazy and arranges a participation where there is some sharing in the administration of the loan, then headaches may ensue. It is important that the borrower know who will be administering the construction loan, and that they are competent to do so.

ABOUT THE AUTHOR: Banking Consultant & Expert Witness Don Coker
Expert witness and consulting services. Over 480 cases for plaintiffs & defendants nationwide, 115 testimonies, 12 courthouse settlements, all areas of banking and finance. Listed in the databases of recommended expert witnesses of both DRI & AAJ.

Clients have included numerous individuals, 70+ banks, and governmental clients such as the IRS, FDIC.

Employment experience includes Citicorp, Ford Credit, and entities that are now JPMorgan Chase Bank, BofA, Regions Financial, and a two-year term as a high-level governmental banking regulator.

B.A. degree from the University of Alabama. Completed postgraduate and executive education work at Alabama, the University of Houston, SMU, Spring Hill College, and the Harvard Business School. Called on by clients in 30 countries for work involving 60 countries. Widely published, often called on by the media.

Copyright Don Coker

More information about Don Coker


While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.
For specific technical or legal advice on the information provided and related topics, please contact the author.

Find an Expert Witness