When applying for a construction loan, developers must present a comprehensive project feasibility study that clearly outlines the risks, financial structure, and overall viability of their development. Lenders rely heavily on this study to evaluate key factors such as market risk, construction risk, project location, presales, borrower and builder experience, and cash equity contributions.
Two essential components of this evaluation are the construction valuation and the Quantity Surveyor (QS) report, which together help lenders assess market risks, the cost to complete, and the project timeline.
In this guide, we will walk through how construction loan lenders assess project feasibility, focusing on the roles of construction valuations, QS reports, Project Site Related Value (PRSV), and soft equity.
Additionally, we will discuss how lenders evaluate individual and combined risks, conduct sensitivity analyses, and impose conditions to mitigate overall lending risk.
A well-prepared project feasibility study provides a comprehensive financial analysis, outlining the project's revenue potential, construction costs, and timelines. This document forms the foundation for a construction loan lender's decision-making process. It must demonstrate the financial viability of the project by addressing key areas:
Lenders assess market risk to determine if there is sufficient demand for the type of property being developed. A thorough market analysis should include comparable sales, absorption rates, and demand forecasts to show alignment with current market trends.
Construction risk encompasses potential cost overruns, delays, and builder insolvencies. Lenders mitigate these risks by conducting due diligence on the builder’s financial stability and experience.
A critical aspect of a construction loan assessment is determining the Project Site Related Value (PRSV), which represents the adjusted land value necessary to achieve a target profit margin—usually around 20%. The PRSV often generates soft equity, which is the difference between the land's purchase price and the adjusted PRSV.
The feasibility study plays a crucial role in justifying the PRSV and validating the soft equity generated. Developers must provide detailed market analysis, revenue projections, and comparable sales data to demonstrate that the PRSV is realistic and aligns with market conditions.
For a construction loan to be approved, lenders must have confidence in the cost to complete and the proposed project timeline. Any delays or cost overruns can undermine the profitability of the project and the lender’s ability to recover their loan.
The QS report is an independent document outlining the remaining costs to complete the project. This report provides construction loan lenders with confidence that the project will not encounter funding shortfalls. It also verifies that the construction budget aligns with the feasibility study.
Lenders depend on the QS report to establish a realistic timeline for project completion. Any delays in construction can erode profitability, so the QS ensures the timeline is achievable within the loan’s term.
Lenders break down individual risks, such as market risk, construction risk, presales, and borrower and builder experience before assessing their interaction. Evaluating these risks individually and collectively provides construction loan lenders with a comprehensive understanding of potential challenges.
For example, a project may have low market risk but high construction risk due to an inexperienced builder. Conversely, high presales may reduce market risk but still leave overall risk elevated if construction costs are underestimated. By combining these risk profiles, lenders gain a holistic view of the project’s overall feasibility.
Lenders use sensitivity analysis to stress test the project’s viability under different scenarios, such as cost overruns, delays, or reduced revenue.
After evaluating the feasibility and conducting stress tests, construction loan lenders often impose specific conditions to protect their investment and mitigate risk. These conditions help ensure that the development stays on track and addresses identified risks.
A well-prepared project feasibility study is the cornerstone of how construction loan lenders assess the viability of a development. By carefully evaluating market risk, construction risk, and the overall financial structure of the project and reinforcing this with a stress-tested sensitivity analysis lenders can mitigate risk and safeguard their investment. Developers must ensure that their feasibility study thoroughly addresses these concerns to secure favourable loan terms and ensure the project's success.