In the wake of rising insolvencies in the Australian construction industry, construction loan lenders are becoming increasingly vigilant when conducting due diligence on builders for residential property development loans. With construction companies accounting for around 27% of all insolvencies in Australia despite contributing only 9% to the nation's GDP, the risks of funding these projects have become significant. Insolvency within the construction sector can lead to project delays, budget overruns, or total project abandonment, placing both the lender and the property developer at risk.
Understanding the Importance of Builder Due Diligence in Construction Loans.
Alignment of Interests Between Construction Loan Lenders and Property Developers
The financial interests of construction loan lenders and property developers are naturally aligned, as both parties have a vested interest in seeing the project completed on time and within budget. For the property developer, the successful completion of the project ensures a return on investment through sales or leasing, while for the lender, completion ensures the repayment of the loan and minimises the risk of default. This alignment drives both parties to work closely to mitigate construction risk, especially in an unstable construction industry.
Risk Mitigation Through Builder Due Diligence
Construction loan lenders focus heavily on conducting thorough due diligence on builders to assess their financial stability and ability to manage construction risks. This process involves verifying the builder’s financial health, experience, capacity, and track record to ensure the project has a strong chance of being completed. By assessing liquidity, debt levels, and previous project outcomes, lenders minimise the chance of a builder becoming insolvent mid-project, which would significantly increase the lender's exposure to financial losses.
For the property developer, having a lender complete such in-depth builder evaluations works in their favour as well. It reduces the likelihood of a project stalling due to a builder's financial instability and provides reassurance that the project will continue even in challenging market conditions.
Key Metrics Construction Lenders Use to Assess Builders
1. Information Request for Construction Loan Assessment
To assess a builder’s capability and financial health, construction lenders request a wide range of due diligence documents, which generally include:
- Building Contract Verification: Ensures the contract is arm's length and not an owner-builder arrangement.
- Developer/Builder Strategy: Details the collaboration between the developer and builder, especially if they have worked together before.
- Net Tangible Assets: Assessed to ensure that Net Tangible Assets exceed typically 20% of the project’s value (excluding Related Party Loan Assets), considering the scale of current and future projects.
- Liquidity: Builders must demonstrate unencumbered liquidity of at least typically 10% of turnover to manage cash flow during the project.
- Management Experience: The builder’s management team must show proven experience in delivering similar-sized projects, supported by a capability statement and details of current work in progress.
- Workload Concentration: The bank’s construction loan exposure should not exceed 50% of the builder’s estimated construction workload at the time of assessment.
- Financial Statements: Construction loan lenders typically review the builder’s financials for the last two years, including profit and loss statements, balance sheets, and year-to-date management figures.
- ATO Payments: The builder must provide confirmation that all tax payments are current through Australian Tax Office (ATO) portals.
- Work in Progress Schedule: A detailed schedule that includes information about ongoing projects such as the client, project name, contract type and value, and completion status.
- Aged Debtors and Creditors Report: A review of outstanding payments with clients and suppliers.
- Bank Guarantees and Bonds: A schedule of issued bank guarantees and performance bonds.
- Legal Claims and Disputes: Confirmation of any legal disputes or claims that may affect the project’s viability.
2. Financial Assessment of Builders
The builder’s financial stability is key to securing a construction loan. Construction loan lenders conduct a thorough financial review to ensure the builder can cover construction costs and complete the development within budget and on time. This typically involves:
- Profitability: Evaluating the builder’s profitability to ensure consistent profits and stable cash flow.
- Liquidity: Ensuring builders have sufficient cash reserves to manage the project without relying on additional borrowing.
- Debt Levels: Assessing the builder’s debt-to-equity ratio to ensure they are not overleveraged.
- Working Capital: Ensuring adequate working capital to handle day-to-day operational costs during construction.
- Credit Checks: Conducting a credit review to ensure the builder has a positive credit history.
- Bonding Capacity: Builders may need to secure performance bonds, providing additional assurance that the project will meet the construction loan terms.
3. Role of the QS Report in Construction Loan Due Diligence
The Quantity Surveyor’s (QS) report is a critical part of the construction loan approval process. It provides an independent verification of the project’s costs and feasibility, ensuring that the loan amount is adequate to cover both the costs spent to date and the cost to complete the project. The QS report helps construction loan lenders evaluate the following:
- Total Development Costs: Certifies the total development costs, ensuring that both spent and remaining costs are accurately accounted for.
- Cost to Complete: Certifying the remaining costs to complete is crucial for preventing underfunding, which could cause delays or project failure.
- Loan Term Adequacy: Evaluates whether the approved loan term is sufficient to cover the construction timeline and prevents the project from stalling due to financing expiration.
- Alignment with Feasibility Study: Ensures the QS report aligns with the project’s financial feasibility and the lender’s facility limit to confirm the project is financially viable.
- Capitalised Interest: Ensures that adequate interest coverage is built into the loan to cover the construction period.
4. Experience and Track Record for Construction Loan Approval
A builder’s experience and track record are critical factors in construction loan approval. Construction loan lenders examine the builder’s ability to successfully complete similar projects by assessing:
- Project Portfolio: Ensuring the builder has completed projects of similar size and scope.
- Reputation and References: Conducting reference checks with past clients, subcontractors, and industry peers, focusing on the builder’s ability to:
- Complete projects on time and within budget.
- Maintain high-quality construction standards.
- Address issues during or after construction.
- Litigation History: Reviewing the builder’s legal history to assess the potential risk of ongoing or past disputes affecting the project.
5. Capacity and Resources to Complete Construction Loans
Construction loan lenders assess the builder’s capacity to manage the project alongside other commitments to ensure they are not overextended:
- Workload Capacity: Analysing the builder’s current and future workload to determine if they can complete the new project without overextending resources.
- Subcontractor Relationships: Assessing strong subcontractor relationships to avoid delays.
- Project Management Capabilities: Evaluating the builder’s use of project management tools and systems to ensure the project can be completed on time and within budget.
6. Licensing and Compliance for Construction Loans
Compliance with legal and regulatory standards is essential for securing a construction loan:
- Licensing: Confirming that the builder holds the appropriate licenses to perform the required work.
- Building Code Compliance: Ensuring builders demonstrate compliance with Australian building codes and regulations, as non-compliance can jeopardize the construction loan.
7. Insurance Coverage for Construction Loans
Adequate insurance is vital to protect the builder, lender, and the project throughout the construction process. Construction loan lenders ensure that the builder has the necessary insurance before granting a construction loan:
- Public Liability Insurance: Covers potential damages to third parties or property.
- Contract Works Insurance: Provides protection against physical damage to the project during construction.
- Professional Indemnity Insurance: Covers any errors or negligence during the design and construction process.
- Workers’ Compensation Insurance: Ensures coverage for injuries or accidents on the construction site.
Demonstrating the Builder’s Financial Responsibility
To further demonstrate their capability and ensure project success, builders must also secure solid cost coverage from suppliers and subcontractors:
- Fixed-Price Contracts: Presenting fixed-price agreements with suppliers and subcontractors to mitigate risks of cost fluctuations.
- Detailed Quotations: Providing multiple quotes from key suppliers and subcontractors to confirm competitive pricing.
- Ongoing Cost Monitoring: Demonstrating systems in place for tracking and updating cost estimates as the project progresses.
Conclusion
The due diligence process for construction loan lenders plays a crucial role in safeguarding both the lender and the property developer from potential financial losses stemming from builder insolvency. By assessing financial stability, experience, capacity, and legal compliance, lenders can mitigate risks and improve the chances of a project’s successful completion. This process not only protects the financial interests of all parties but also ensures that construction projects are delivered on time, within budget, and to the required quality standards, even in a volatile construction market. Ultimately, thorough due diligence fosters a collaborative and risk-conscious environment where lenders, developers, and builders can align their goals for successful project outcomes.
