Changes in the Construction Industry. The lack of demand for services in the recession forced many of the contractors, sub-contractors and their laborers to exit the industry. So, when the development and construction lending industry engine roared back to life afterwards, it was only a matter of time before the supply of contractors and labor that fuels that engine would start to run short. Contractors and material suppliers are now making contract demands that were previously rejected, such as bi-weekly payments versus monthly payments and larger deposits for stored materials or off-site production.

Contractors are also working hard to create efficiencies to minimize the impact from the looming labor shortage. For instance, improvements in technology have facilitated faster and more accurate cost projections to decrease the number of time and budget overruns. Construction method improvements have decreased the need for as much labor in general and in particular as much skilled labor on site as was needed in the past. The biggest change recently has been the dramatic rise in large scale off-site or component construction in climate and quality-controlled facilities located in rural areas, where labor is less expensive.

Risks Old and New. These contractor demands create new risks for developers and lenders. Lenders are being asked to fund imprest or working capital accounts to cover the bi-weekly payments to contractors which puts half a month to a month of draw fundings at risk. Efficiencies created on the estimating side mean that developers may be asking for less contingency that if anything shifts sideways during construction could more quickly push the loan out of balance.

The risks of newer, less experienced contractors entering the market are amplified with newer, less experienced lenders also entering the market. These new risks are combined with the inherent construction risks like weather delays, material costs (that are already being impacted nationwide by post Hurricane Harvey repairs in Houston), permitting delays, and labor costs.

Protections for Lenders. With all these risks, except for the higher returns, one might wonder why anyone would go into construction lending at all. Fortunately, construction lenders have to date, been very prudent in their due diligence, appropriately cautious in their underwriting and humble in their willingness to admit what they don't know and to hire additional resources to help them when needed.

Lenders are protecting against budget risk by incorporating in the loan documents subcontract buyout percentage requirements (typically from 70% to 90% and at least for all major trade contractors) prior to their advancing money into the deal or at least prior to the first funds advanced after acquisition. They are protecting themselves against increasing cost risk and contractor risk by requiring payment and performance bonds and sub guard insurance at higher levels than ever before and for at least the major trades. Loan-to-cost ratios are still holding around 75% to 85% maximum, including mezzanine debt.

Experienced and inexperienced lenders alike are hiring real estate advisors like Trimont and construction consultants to visit the sites to monitor work progress, proactively ferret out issues prior to them becoming critical, and review draw packages with invoices, lien waivers, change orders, budget reallocation requests, deposits and stored material requests with insurance evidence each month in detail to ensure the projects are progressing on schedule and on budget. Trimont has been proactively performing this service (typically paid for by the borrowers), reviewing loan documents prior to closing, servicing the loan (or loans for syndicated or participated deals) including monitoring the tax and insurance payments and provisions, administering the interest and construction reserves, and reviewing condominium contract and closing documents for condo deals successfully for clients on a large and small scale for decades.

With all the protections and monitoring resources available today, lenders should feel comfortable continuing to make construction loans to experienced developers on reasonable projects in the right markets especially if, as we suspect, the construction lending engine begins to level off to a stabilized rpm in the next six-12 months.

Thomas J. Wise is managing director of asset management for Trimont Real Estate Advisors. The views expressed here are the author's own.