I have heard the following statement many, many times over the course of my career: “Do I really need to hire an attorney to close a simple commercial construction loan?” Needless to say, I cringe each and every time. While everyone loves to keep loan closing costs to a minimum, there are hidden costs of not being represented by counsel that could far outweigh this perceived up-front savings. Below are five examples of standard commercial loan documentation concepts that warrant careful review by borrowers and their counsel before any loan documents are executed.
- Interest Reserves. Many construction loans contain an interest reserve, which allows the interest payments that become due during the construction period to be paid out of loan proceeds. How and when a lender is required to disburse this reserve should be carefully considered. A borrower without access to interest reserve funds could lead to a payment default, resulting in the delay or a freeze on access to construction funds.
- Sales/Leasing Covenants. After completion of the construction project for which the financing was obtained, many commercial construction loans contain a semi-permanent term, during which principal payments commence. Sales or rental requirements during this semipermanent term are fairly common. These covenants usually require a certain number of sales or amount of space leased during each designated testing period—monthly, quarterly, semi-annually or annually. While initial expectations for project performance always appear attainable, it is not uncommon for issues, problems and market changes to occur. Therefore, creating options in these provisions that allow a borrower to cure a covenant violation before it rises to the level of a default under the loan documents is critical.
- Mechanic’s Liens. The filing of mechanic’s liens by a contractor or subcontractor can be a routine part of a construction project. It goes without saying that a lender does not want such liens encumbering its collateral (whether superior or subordinate to the mortgage lien). However, it is important that the construction loan documents permit a borrower a period of time to have the lien(s) discharged or bonded over. If the filing of a mechanic’s lien in and of itself constitutes an immediate default, there is likely to be a delay or a freeze on access to construction funds, and in turn, a delay to the completion of the project.
- Retainage. Retainage is the term used to define the portion of loan proceeds that will not be advanced to a borrower until the project is complete. It is used to ensure that the project is completed and is completed in an acceptable manner. A borrower, as the owner of the project, will in turn withhold the same, or similar, portion of the payments due to each contractor and subcontractor. The percentage of the retainage held back by a lender as the project progresses, as well as the release of the final retainage, should be carefully reviewed and negotiated to fit the particular project being financed.
- Permanent Lending Requirements. Given the short-term nature of a large majority of construction loans, many lenders want an opportunity to provide the permanent, long-term, financing for the project, once completed. The terms of a lender’s ability to have a right of first offer or last look at the permanent financing and any fees that could be incurred if a borrower selects a new lender for the permanent financing should be carefully reviewed and negotiated.
This article contains a small sampling of terms contained in almost all commercial construction loan documents, which require careful review, consideration and negotiation. If such terms are not properly drafted to fit a particular project, the result could be additional, unexpected costs to a borrower, something we all want to avoid. Being represented by seasoned construction finance counsel could, over the life of a construction project, end up saving a borrower exponentially more than the up-front cost.