Troubleshooting Construction, Through the Bank's Eyes
A bank's inspector relied on his construction project experience
I had seen a lot in more than 30 years as a construction project manager in three states, not to mention what I had seen in two tours of duty in Vietnam in 1965 and 1966, as a company commander with U.S. Naval Mobile Construction Battalion 10. But some of the most interesting challenges came when I went to work for Corus Bank in Chicago, in charge of progress inspections and disbursement of construction loan funds for a $6-billion loan portfolio.
Needless to say, my experience managing construction sites helped.
Few people appreciate what a bank's construction inspector actually does or how the inspector qualifies for the job. Most progress inspectors are employees of the lead architectural firm and are well qualified to verify the accuracy of each line item in a pay request. But a bank inspector who has a background as a construction project manager can perform the monthly progress inspections with more insight than someone who is just verifying numbers. That insight can lead to cost-effective problem solving.
My own transition from construction management to staff work for construction lenders had an easy start. I learned that a monthly progress pay request is a snapshot in time of a typical construction budget. My second big step in gaining understanding of the lending game was to master the typical loan agreement, which defines and controls the loan. Knowledge of the loan agreement and a full understanding of construction site operations helped me protect the banks' risk exposure and loan servicing needs.
The construction lender’s biggest fear is a project failure that requires the lender to declare the borrower in default. That can require the lender to take ownership of the real estate. And it means that the payback of loan funds will be delayed and unbudgeted costs will be incurred by the bank.
The bank’s borrowers, who are the project owners, are always looking for ways to reduce costs, and changes initiated by the owner almost always result in schedule delays of some form. A diligent bank inspector always watches the number of change orders that have been initiated at the monthly architect-owner-contractor meetings. The inspector must understand the interchange between cost saving and potential scheduling delays.
It is possible that the owner's goals of cost savings can conflict with the lender's goal of a timely project completion. Timely completion of the project triggers the beginning of the scheduled repayment to the lender of construction loan funds. These conflicting goals don’t necessarily cause a problem. If the interest reserve and the contingency, which are budgeted into the loan agreement, are in proper order, the loan remains in balance. (The interest reserve is a fixed amount of the loan funds that is drawn by the borrower to pay the current interest charge.) If these two budgeted amounts are drawn down by the borrower in proportion to the project progress, they are considered to be in order. If they are seriously depleted, well above the rate of project progress, the bank may require the owner/ borrower to put new, additional funds back into the loan account.
When the problems involve a $100-million condominium project (part of Corus Bank’s portfolio of 120 project loans in 17 states), which happened at the time I worked there, the bank sees the issues with more urgency. The problem cropped up just before condominium closings were about to begin. My boss, the head of commercial lending, asked me to fly to Miami to check on a serious problem that would delay the start of loan repayment.
More than four dozen leaks had been found in the newly constructed fire sprinkler system of the new, 51-story building. A lab report showed that the PVC material used by the subcontractor had numerous defects caused by impurities in the material. The borrower's current plan was to rip out the entire fire sprinkler system and rebuild it from the ground up. That could take months, delaying the condominium closings and the loan payback, and would give the condominium unit buyers contractual justification to back out of their purchases.
Seeking Leak Locations and Pattern
The first thing I wanted to know was the location of the leaks to see if there was a pattern to their appearance. I also asked who had taken the defective material samples to the lab for testing.
Information had been provided to show that the leaks were clustered in groups. The leaks appeared to be concentrated on three floors of the 51 story building. Defective material would have shown a random pattern of leak locations throughout the building. It turned out that the defective material samples had been carried to the lab by the subcontractor who had constructed the fire sprinkler system. As an old project manager I had seen the results of poor workmanship and the games played with lab reports. They couldn’t be trusted.
After my visit to the site, new PVC samples from the immediate leak locations were taken to the lab and found to be free of defects. Four dozen leaks and the associated finishes were repaired in short order and the unit closings and loan payback remained on schedule.
There were other examples of where my construction experience helps such as loan disbursements for materials in storage. The usual procedure is for the bank to provide funds for those materials after documents are provided with an inventory of material and a bill of sale and verification from a bonded warehouse.
We looked past that procedure at least once, for good reason. A general contractor had requested $600,000 from one of our borrower-developers for a deposit on granite counter tops. The granite had not yet been loaded into shipping containers at a Chinese port. But I recommended making the $600,000 payout. Why? The bank was currently holding over $20 million in retainage and the project was ahead of schedule and very well managed. Very little use of contingency funds had occurred. In other words, the lenders exposure on this payout was limited.
As sharp as our senior loan officers were they often did not know the basic vocabulary and procedures that construction managers deal with daily. Yet they had the power to stop or continue the flow of project funds – and shape the outcome of the project for better or worse.
Chicago-based John Zander is a consultant to banks on construction projects. He can be reached at firstname.lastname@example.org