Construction Loan Risk: Monitoring Risk During Construction
Recognize Developer and Market Risks
Projects financed through future asset sales carry additional repayment risk. A common example is a condominium development where construction is financed through a construction loan with the expectation that the loan will be repaid through the sale of the individual units.
If unit sales fail to keep pace with construction progress, the developer may be unable to generate sufficient revenue to repay the loan. A developer facing weak sales may also lack the liquidity to absorb cost overruns, subcontractor defaults or unforeseen events. What begins as a sales issue can quickly become a financing issue, leaving lenders exposed where the anticipated source of repayment is no longer sufficient to retire the loan.
Monitor Early Signs of Financial Distress
Payment disputes are often among the earliest indicators of financial stress. Complaints from trades, repeated notices of non-payment, delays in progress certification and disputes over change orders should all prompt further investigation.
Supply chain disruption, rising labour costs and material price escalation can quickly increase construction costs. Although construction contracts typically allocate responsibility for these risks, lenders should also consider whether the responsible party has the financial capacity to absorb them. If not, the project may require additional financing to reach completion.
Each draw should also be assessed against the project’s progress. Construction loans are typically advanced as construction milestones are achieved. Advancing funds ahead of the project’s progress increases the risk of borrower default and may leave the project underfunded before completion.
Independent consultant reports, payment certificates, statutory declarations and site inspections help verify progress. Repeated change orders, significant cost overruns, supply chain delays, subcontractor defaults and schedule slippage should each be treated as warning signs rather than isolated events.
Monitor Subcontractor Default and the Use of Project Funds
Construction projects operate within a contractual hierarchy. When a subcontractor defaults, the financial consequences rarely stop with that subcontractor. The resulting costs are often absorbed by the general contractor. If those costs cannot be absorbed, the financial pressure may ultimately affect the owner’s ability to complete the project and repay the construction loan.
Construction loan proceeds are advanced for the project and should be used for that purpose alone. Where funds are diverted to cover operating expenses, service unrelated debt or support other business operations, contractors and suppliers who have provided labour and material may be left unpaid. Lenders should obtain reasonable assurance that previous advances have been applied to legitimate construction costs before releasing additional funds.
Where project funds are misappropriated, the owner's directors may also face personal liability under the trust provisions of the Construction Act, R.S.O. 1990, c. C.30. Understanding how these risks interact can help lenders identify financial distress before it develops into a broader project failure.
The Bottom Line
Many of the greatest risks associated with a construction loan emerge after the initial funds have been advanced. Monitoring the financial health of a project throughout construction can help identify warning signs early, reduce risk and support better lending decisions.
HOW WE CAN HELP
RAR Litigation advises lenders, developers and other construction industry participants on the legal issues that arise throughout the construction financing process, including mortgage priority, construction liens, payment disputes and project risk. If you have questions about construction financing or issues affecting a construction project, contact our team for strategic legal advice.