As the competition for construction loan projects remains at unprecedented levels in much of the country, lenders are frequently being asked to waive, modify or re-visit their standard construction loan credit enhancement requirements. The following is a brief look at some of the more common credit enhancements required by lenders and the benefits and shortcomings of each.
Guarantees continue to be the most common credit enhancement for balance sheet lenders on small and medium-sized construction loans. Lenders generally obtain either a payment guaranty, a completion guaranty or some combination of the two from key principals of the developer. Obtaining guarantees from developers with significant assets and liquidity is obviously ideal, however, obtaining guarantees from principals with limited financial resources can still be helpful as these principals are less likely to walk away from a project with the threat of the enforcement of a guaranty hanging over them.
Payment guarantees are best, but they may not always be available due to the competitive landscape for a particular project or developer. Completion guarantees, while helpful for the same “skin in the game” reason pointed out above, tend to be far less reliable credit enhancements for a lender. Generally, courts will not require the guarantor on a completion guarantee to “specifically perform” the developer’s obligations under the loan and cause the completion of project. Instead, a lender will need to sue the completion guarantor for the damages the lender has incurred as a result of the project not being completed under the terms agreed to in the construction loan documents. Damages under a completion guarantee can be fairly difficult to prove and require expert witness testimony. The damages are subject to varying calculations based on competing appraisals presented by the lender and guarantor and oftentimes will be non-existent if the current value of the land and the partially-completed project are determined to exceed the outstanding balance of the loan.
Payment and Performance Bonds
Payment and Performance Bonds (P&P Bonds) are often a standard requirement for construction lenders, but, like guarantees, pose their own set of limitations. A P&P Bond is an insurance contract made by a surety company under which it insures that its “bonded” contractor will (1) complete a construction project under the terms agreed to by the contractor and the developer and (2) pay its subcontractors. A construction lender may become a beneficiary of a P&P Bond by being named by the surety company as a “co-obligee” pursuant to a dual-obligee rider attached to the P&P Bond.
While P&P Bonds can be very useful to construction lenders (especially in instances involving inexperienced or undercapitalized developers), they often can be difficult to obtain. Not only do they drive up the cost of a project, P&P Bonds are generally only available to more established and well-capitalized general contractors. Even when available, P&P Bonds can be difficult to collect on as a result of shortened deadlines in which to assert claims and other standard limitations and restrictions contained in the bonds, resulting in protracted and expensive litigation to determine a construction lender’s actual coverage under the bonds.
Letters of Credit
Letters of Credit tend to be less common credit enhancements for a lender providing construction financing, but can serve as an attractive alternative when P&P Bonds are not a viable option. An irrevocable, standby letter of credit is the unconditional obligation of an issuing bank to, for a specified period of time, pay the beneficiary of the Letter of Credit (i.e., the construction lender) all or some portion of the face amount of the Letter of Credit upon the beneficiary’s demand and presentment of the Letter of Credit to the issuer. The terms of the loan agreement detail when the construction lender may draw upon the Letter of Credit – typically, an event of default under the loan or the failure of the borrower to renew the Letter of Credit prior to construction completion or loan repayment.
Unlike P&P Bonds and Guarantees, Letters of Credit provide, for the most part, more readily available access to cash for a construction lender and fewer obstacles to obtaining it. Like P&P Bonds, however, Letters of Credit are expensive (even more so) and require that the applicant-developer either be well capitalized, provide collateral security to the issuer, or both.
Each of the above credit enhancements continues to play a significant role in construction financing. Understanding the economics, benefits and limitations of each is a critical component to determining when and how each may be used to enhance the credit of a construction loan.