Bridge, CLOs and Construction Risk: 6 Questions To Ask

Collateralized Loan Obligations (CLOs) and bridge lending hit record levels in 2021, driven by market uncertainty, a large inventory of transitional assets and an insatiable demand from the debt capital markets.  Feedback from our clients confirms that they see no sign of the CLO market slowing in 2022.

These loans “bridge” the gap between acquisition and permanent financing and the CLO structure provides funding mechanisms for the sponsor to implement the necessary renovation or redevelopment required to stabilize the asset.  Proper execution of the renovation/redevelopment plan by the sponsor is integral to the success of the loan and experienced CLO originators understand the need to manage the construction risk associated with these projects.

As a bridge or CLO lender, are you properly quantifying and underwriting the risks associated with the construction component of the loan?  What risk management protocols do you have in place?  Are they enough?

With so many fresh players entering the bridge lending and CLO space in the last two years we have seen some that aren’t doing enough to mitigate risk.  This can cause delays, cost overruns, or worse – loan default.  Gain greater certainty of execution by asking yourself and your consultant these questions:

1. Do you have internal technical expertise in construction?  

Construction is complicated and inherently risky.  Don’t wing it!  If you don’t have an in-house construction risk management professional, or simply don’t have the manpower to commit to having eyes and ears overseeing the project, a third-party consultant is your best bet to mitigate risk and protect your investment.  And if you do have in house technical expertise be clear about what you want to handle in house and what tasks you expect the consultant to be responsible for.

2. How big is the construction budget and how big is your risk appetite? 

What is the hard-cost construction budget?  What percentage of the loan proceeds are earmarked for the construction component?  What level of risk are you comfortable assuming?  These factors will help determine your level of due diligence.  In our experience, about 25% of bridge and CLO loans only need a one-time upfront budget review (as the construction costs are not a large percent of the loan), and about 75% require at least some ongoing construction progress monitoring.  It is critical for your due diligence professional to understand how granular you want them to get within the loan.  For larger construction projects, you may want to go more in depth, for example by getting additional details on the subcontractors.

3. Are the budget and schedule of the rehab/renovation/completion realistic?  

To evaluate this for CLOs and bridge loans, we typically recommend doing a Document and Cost Review (DCR) as well as a Property Condition Assessment.  For some projects a more limited Budget Review can be done and for others a high-level budget opinion can be incorporated into the Property Condition Assessment.  At a minimum you should have these four documents reviewed by your consultant to better evaluate the project:

• Complete budget
• Final schedule
• inal contract (not to be changed before executed)
• Stamped/Signed drawing, plans, & specs

Other documents that may be requested/reviewed by your consultant (if available) include:

• Construction subcontracts and/or purchase orders
• ALTA Survey
• Affidavit of compliance
• Zoning approvals
• Environmental reports
• Geotechnical report
• Permits
• Utility letters
• Insurance certificates and bonds

4. How do you verify percentage complete and what are the triggers for release of funds?  

The vast majority of construction defaults occur due to lack of oversight in the payment process.  Having qualified inspection services to verify percentage complete, progress according to schedule, as well as continuing to balance the requests in-line with budget helps protect against default.  This is especially important for projects where the construction hard costs are high enough to warrant greater risk management controls.

5. What is your comfort level with the contractor?  

A Contractor Evaluation – where we evaluate the contractor’s experience and capability as it relates to the project a hand – is not always necessary for bridge loans. You may consider getting one if you don’t know the local players, or if something seems off – for example, bids come in well below market expected or with a schedule that may not seem correct.

6. What is the takeout? 

At the end of the CLO or bridge loan, how is the lender going to get paid back (sale of condo units, permanent financing, etc.)?  Make sure your level of due diligence is commensurate with the level of due diligence that will be required to make you whole when the loan term is up.  For example, if the permanent financing will be from Freddie Mac or Fannie Mae, they will need to have an affidavit of compliance that the plans comply with agency specific requirements.

Above all, good communication with your third-party consultant is key!  Every project and every client is different.  It is our job to ask the right questions and help guide you to the level of oversight appropriate for your institution and the particular transaction at hand.