Industry Still Wary of Construction Risks, Partner Survey Shows

NEW YORK—Regulatory concerns are the principal focus for more than a third of the lenders participating in a newly released survey on construction risk produced by GlobeSt.com with Partner Engineering and Science Inc.

Some 37% of lenders in the survey—which also queried developers and investors— said regulations and bank audits are the primary drivers of risk management policy in their institutions. Weighing on lenders' decision-making to a lesser degree were policies dictated by other stakeholders in a project; and preventing loss (from lawsuits, engineering or non-engineering causes). 

At the forefront of developers' and investors' minds were anticipating variables like market trends, subcontractor defaults, labor shortages.

“Solving the puzzle of uncertainties – changing real estate conditions, construction trends, financial markets and other variables – continues to present developers with a fascinating, and profitable, challenge,” says Ken Sisk, PE, Partner's national client manager, consulting & engineering services. “Feasibility reports require an understanding of market-based ambitions along with engineering and entitlement constraints.”

The study, Building Momentum: Construction and Risk in a Post-Recession Era, is available for free download from GlobeSt.com.

The survey responses suggest that while the industry's prospects appear to be improving over the near term, the financial crisis of 2007-2008—and its lessons about prudent underwriting and deal selection—is still very much in the minds of market participants as they evaluate credit and construction risk of the deals presented to them.

“A single failure can wipe out the profits from a dozen loans.  It's important for lenders to stay abreast of market risks in order to protect assets and maximize profits,” notes Partner's Brian Ward, technical director, construction risk management.

While the industry may seem more focused on construction risk management than before the financial crisis, survey respondents confirmed that construction risk management is handled differently among various institutions.

“People's roles within their institutions really affect how they see the deal, the risks involved, and how they approach risk management,” observes Bill Tryon, Partner's director of strategic development.

Respondents also said due diligence had become a more important factor in evaluating projects, including the use of feasibility assessments, property condition assessments, and document and cost reviews.

“Bank regulation is a substantial force in the industry that affects regulated institutions and could even create opportunity for non-regulated institutions in areas like construction lending,” says Joe Derhake, PE, Partner's president.

Among the issues that seem to be keeping lenders awake at night are the need to balance risk management with remaining competitive, while also responding to regulatory pressures. Developers are mainly concerned with being able to anticipant market demand, labor availability, and subcontractor performance.

With only about one-third of the respondents indicating that construction risk due-diligence is handled mainly in-house, it's nevertheless important for market participants to have expert help with this important review.

“It's important for lenders to have internal resources experienced in reviewing the technical due diligence reports,” says Partner's Bill Tryon. “For lenders that don't have such staff, they typically have a few options – cross train internal staff, hire someone, outsource it to a 3^rd party firm, or some combination of those.”

On a brighter note, there was widespread agreement that markets were poised for strong growth over the next year, in at least six of the ten sectors—single family, hospital/healthcare, multifamily, mixed-use, retail, and distribution/warehouse. Regionally speaking, respondents reported an expectation of higher construction costs in all areas, but especially in the West.

“The west is hot, but challenging as inflation in construction costs are more pronounced in California and Washington,” notes Sandy MacLean, Partner's technical director, construction risk management.

Respondents also indicated they have little concern about labor shortages, regardless of the geographic region.

Ultimately, if the financial crisis has made lenders and developers more aware of the risks they need to monitor, keeping a close eye on their risk management policies is going to be a positive development for the commercial real estate markets. But as Bill Tryon notes, “Banks should not let regulators drive their policy. Banks profit by taking risks. The most successful lenders take steps to understand and mitigate risks in order to maximize profitability.  Policy must balance competitiveness with risk management.”

In the final analysis, robust advance planning, coupled with solid risk management policies and open lines of communication appear to be the best defense.

As Ken Sisk notes, “Short of predicting the future, the best way to protect yourself is thorough due diligence, plan ahead, put a lot of contingencies in place, have great communication between all parties, and work with a team you really trust.”