Monitoring Loan Risk During Construction

Monitor Early Signs of Financial Distress

Multiple payment disputes are often an early symptom that a project is experiencing financial distress. Complaints from trades, repeated notices of non-payment, delays in progress certification and disputes over change orders should all invite 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 be examined and properly 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 Owner and Contractor Defaults, Construction Liens and the Use of Project Funds

Construction projects operate within a contractual pyramid: payment flows down it, and so too do the consequences of a default. When an owner fails to pay the general contractor, or the general contractor fails to pay its subcontractors, the shortfall passes down to the trades and suppliers who have provided labour and materials to the project. Those unpaid parties can then look to the property itself for payment by preserving construction liens.

Liens can directly affect the priority of the lender’s security. Under s.78(4) of the Construction Act, R.S.O. 1990, c. C.30 (the “Act”), a mortgage registered before the first lien arises generally retains priority over liens, including for later advances. However, an advance made while a preserved or perfected lien is registered, or after the lender receives written notice of a lien, loses that priority. Priority is therefore tested at each advance, not only on registration. Lien claimants also have priority over the mortgage to the extent of any deficiency in the holdbacks the owner was required to retain. In addition, we have previously explained a further risk: a lender can lose priority to other claimants even where, at the due diligence stage, it had no knowledge that anyone had performed work on the project.

An unpaid contractor or subcontractor may register a lien or give the lender written notice of it at any time during construction. Before releasing each draw, lenders should obtain an updated title search to identify any registered liens and confirm that no written notice of a lien has been received. If a lien has been registered or notice given, advancing further funds before the lien is vacated or discharged can place that advance behind not only that lien, but other liens arising from the same project.

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 materials 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 Act. Similarly, if the lender fails to make inquiries to determine whether proper measures are in place to see that the contractor is paid, the lender will be liable for the breach of trust arising out of the diversion of funds. Understanding how these risks interact can help lenders identify financial distress before it develops into a broader project failure.

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.

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.