5 Questions to Ask About Your Construction Finance Package

Construction lending is big business in the US, and access to construction loans for commercial real estate has become more competitive in recent years. There is often significant time pressure to close a loan and move a project along, in order to take advantage of a market opportunity or hit the construction season. Construction lenders may skimp on due diligence review of project design and construction contracts under these pressures, assuming that they are standardized contracts or that loan documents or consents to assignment cover all the bases.

But myriad issues can lurk in design and construction contracts that can derail a project, leading to significant and costly challenges that make a project an inefficient investment for everyone involved. Cost and schedule overruns, a steady flow of change orders and intractable disputes are common on construction projects, and are exacerbated greatly by inadequate project contracts. Taking the time to diligence contracts in advance of closing can save time and money in the long run, for lenders and borrowers alike.

Knowing the right questions to ask at the outset can uncover flaws in project contract structure and drafting, allowing the parties to resolve the issues before it is too late. Below are five key questions that can flush out some of the most costly and time-consuming causes of disputes. These issues carry risk for the lenders in terms of administrative time and the potential for stepping in to a troubled project. These issues are equally important for developers and owners, who can streamline the loan approval process, saving time and money and protecting their own interests as well, by taking a close look at these topics at the outset of the development of a project.

Why are we using these contracts?

I ask this question as a starting point whenever I am diligencing contracts on behalf of a lender (or representing an owner or contractor). Design and construction contracts take many forms. Often parties use industry standard forms, like the American Institute of Architects suite of forms, modified for the particular project. But it is also quite common for parties use bespoke forms that were crafted on either the contractor side or the owner side. You can learn a lot by asking certain questions about the proposed approach to contracting before even digging into the documents. Why are the parties using particular forms and who created them? Were these documents used on a prior project? For the construction, why did the parties choose a guaranteed maximum price or a lump sum? Why did the parties choose construction management, design-build or other delivery methodologies? These initial questions can flush out whether there’s a good rationale for why particular forms are being used and who had control over contract structuring. This can give some hints as to whether the documents may be biased in favor of one party or another, whether the documents may include negotiated terms from a past project and whether the parties have a sensible explanation for why they were choosing the particular delivery methods and pricing models. The answers often lead to additional inquiries and paths of diligence.

What is this really going to cost?

You would be surprised at how many time I pick up contracts and decipher that the pricing is not even included in the contract or is subject to fluctuation. If a contract is “cost plus” pricing, it’s critical to ensure there’s a guaranteed maximum price. Sometimes, the parties enter into a contract agreeing to establish the guaranteed maximum price or fixed price at a later date. The details around how and when that will be established are important for a lender to understand, as well as how payments will be calculated and capped before that point. Additionally, even if a contract includes a fixed price or a guaranteed maximum price, contractors are increasingly requesting allowance amounts, cost escalation mechanics or change order provisions to cover uncertainties in costs like materials, labor, changing tariffs and other matters. These types of provisions can lead to huge cost fluctuations and need to be carefully vetted and negotiated. Other critical items to review that relate to cost and flow of payments include: (i) retainage provisions (including ensuring there is specificity around release of retainage for the contractor and subcontractors whose work may be completed early on in the project) (ii) cost calculations for change orders due to unforeseen conditions, governmental delays and other anticipated events; and (iii) any shared savings provisions for a guaranteed maximum price project.

And how long will this really take?

Construction projects get a bad rap for always completing late. And schedule delays translate directly into lost dollars as well. Having a trained eye review the construction schedule can be very illuminating, especially if it doesn’t appear to be realistic or contain adequate float. The key date that must be included in any construction contract is a guaranteed substantial completion date, and there are often other key guaranteed dates as well. Often these guaranteed dates are calculated from the date of commencement of the work or the date of issuance of a notice to proceed (NTP) by the Owner. It is important to ensure that the contract includes a mechanism to memorialize that commencement or NTP date in writing, in order to avoid later disputes about what was the actual guaranteed completion date. Also, contracts usually contain a list of reasons why the contractor can seek a schedule extension, and often these lists are very broad and open-ended, encouraging liberal claims for schedule adjustment. It is important to carefully vet and negotiate that list based on the agreed approach to risk-sharing for the particular project, local conditions and location. Finally liquidated damages for delay are an important tool in achieving schedule certainty, but have to be properly negotiated in terms of amounts and triggers as compared to any impacts on the loan of delayed completion.

Who is really doing the work?

Of course it is important to vet the reputation of contractors on a project, including financial strength, volume of work in progress and past performance. However, the contractor on a project isn’t the one doing the vast majority of the work, it’s their subcontractors. Construction contracts vary wildly in how much detail they include about subcontractors, including subcontractor selection, performance security, and owner and lender approval rights. Lenders are increasingly interested in having insight into how subcontractors are selected, ensuring competitive bidding and ensuring the lenders have the right to blacklist undesirable subcontractors from a project. Lenders are also interested in understanding the performance security that is required to secure the performance of both the contractor and the subcontractor. And lenders want to be sure that the subcontracts allow for assignment of the subcontracts to the lender. On the topic of subcontractors, a related point is the importance of the lien waiver provisions. Lien waivers are a critical protection for owners and lenders to ensure that title stays clean and that contractors and subcontractors are required to remove liens or bond over liens immediately as long as they are properly paid.

And what happens if disaster strikes?

Nothing is more detrimental to a commercial real estate project than a natural disaster, fire, large large-scale accident or similar matter that causes catastrophic loss. Especially if the contract provisions aren’t clear about who bears which risks. The two most critical protections in these cases are the two “I’s”: Indemnity and Insurance. Lawyers may be the only people who get excited about these topics, but they are a project’s best friend in a doomsday scenario when something goes really wrong.

Insurance is one of the most critical protections for owners, contractors and lenders. It is key for insurance advisors to review the insurance provisions of all of the contracts on a project to make sure that they work together and adequately protect the interest of all of the involved parties. Often insurance sections are skipped over or not tailored in form documents for the needs of particular projects, which can lead to serious issues when there isn’t coverage for a large loss. In addition to coverage requirements, endorsements, amounts and length of coverage, it is of course key to ensure all of the correct additional insureds are specified.

Also critically important, but often not well-understood, are the indemnity terms. Indemnification provisions are designed to protect each party to a contract against claims by third parties for damage and injury caused by the counter-party. The damages intended to be covered by indemnification clauses can be significant, such as death to third parties or large property losses to adjacent property owners and similar matters. Therefore, it is important to really understand the level of liability that is needed to invoke indemnity claims and the scope of the coverage of each party’s indemnity obligations. And lenders have an interest in ensuring that they are named as an indemnified party in case they get sued for one of these damage events.

Asking these questions and investing time on contract diligence of the outset of a project can save time and money and make a project more successful for all parties involved.

Joanna K. Horsnail is a partner in the Chicago office of Mayer Brown LLP and has been practicing commercial construction law for more than 20 years.