Risky Business: Considerations for reducing the risk of a construction project
Building or developing a new property can indeed be a risky business. Managing and overseeing a range of trades, remaining on-side with your bank’s lending terms, and staying on time and on budget are just a few of the concerns that might keep you up at night.
But with some careful attention to a few key areas – regardless of whether the project is for a new or substantially renovated home or commercial development – you can minimize your risks and help ensure a successfully completed project. Here are a few of the main considerations to keep in mind:
- The need for extensive upfront planning;
- Ensuring that the project has sufficient equity to enhance the likelihood of favorable construction financing terms from a lender;
- The value of working with a reputable builder and architect to ensure all aspects of the project are properly managed.
The importance of planning
As an owner, it is important for you to manage expectations at the outset of a project and schedule regular meetings with both your builder and architect throughout the duration of the project to prevent unnecessary mistakes from being made. Planning from the outset is critical, and any work deviations from the original plan should be supported by a properly documented change order, signed off by the owner and the general contractor.
Securing equity and favorable terms for construction financing
A construction project may require that the lender look to the land as the contribution of the owner’s equity when considering construction financing. Construction financing may range up to 75- 80% of the budgeted construction costs. Lenders will advance construction funding based on stages of physical completion of the project. These draw requests are usually at various stages of project completion such as excavation and foundation work, rough framing and enclosure of the building envelope including installed windows and roofing, with further advances being drawn thereafter as construction continues.
Construction loans are generally for a one-year term with 4-6 draws scheduled as the project advances. Each draw request is inspected by an agent of the lender that verifies physical completion of the work. Quantity surveyors typically perform this role on behalf of the lender. Given that construction financing takes place as the stage of completion occurs, it would be wise for any homeowner or borrower to ensure that they have ample savings or bridge financing in the form of a line of credit to fund the time between laying out funds to the trades and the time of receiving ultimate funding from their lender. Not being able to fund trades can ultimately lead to project delays and inefficiencies resulting in potential project cost over-runs.
Subcontractors and the various trades have a right to file a builder’s lien on the property to protect their interests, and a lender will not advance subsequent draws until the lien has been paid out. Lenders also try to protect themselves from being encumbered with a project that cannot be finished because the borrower runs out of funds or, for some reason, unanticipated delays wreak havoc on timing. For this reason, lenders rightfully pay great attention to cost of completing a job to ensure that the owner/borrower always has sufficient equity in the project. This way, any remaining unfunded component of the construction loan has a better chance of being sufficient to complete the project. No lender wishes to be in the unenviable position of realizing on their security which is only compounded with a partially finished project.
By law, statutory lien holdbacks of 10% are required and released only after 45 days from the date of substantial completion. These retention holdbacks ultimately require the issuance of a certificate of occupancy and, at times, formal notification in a published newspaper allowing time for trades to come forth.
Construction financing usually requires interest-only payments, and you will want to ensure that permanent or take-out funding is lined up, upon project completion, to replace the interim financing. Permanent mortgage financing will have more favorable interest rate pricing when compared to the interim construction loan. Loan to value ratios will determine if sufficient value is available to take out the full construction loan.
Working with reputable and insured contractors
As an owner, you and your builder also need to pay attention to insurance for the duration of the project. Your construction loan will require that you or your contractor carries General Liability Insurance, covering harm to people or property caused during construction. Builder’s Risk Insurance, which covers damage to the unfinished building, is also necessary. By law, make sure that your General Contractor carries Worker’s Compensation Insurance for all employees. These types of coverage mitigate any potential damage that you, as an owner, may face if sued by an injured employee or by a passing neighbour should they be injured. Make sure you have this discussion with the Contractor you end up choosing to ensure that they are adequately insured.
In summary, while the rewards can be great, there are many risks when building or developing a new property. These risks can be mitigated by up-front planning, access to sufficient financial resources to ensure project cost over-runs can be dealt with efficiently, and by choosing both a reputable lender and builder with experience and proven track records.