Construction Loans – Key Considerations for Property Developers (Part 2 of 2)

This is Part 2 of my two-part series on construction loans. In Part 1, I covered the loan structure, conditions precedent, the “latest completion date”, cost overruns, interest and default rates, security and charging clauses.  In this post, I cover the remaining key legal and commercial considerations for property developers entering into a construction loan facility in Australia.

What are the pre-sales requirements?

It is common for lenders to impose a minimum qualifying pre-sales requirement.  This is the minimum value (or number) of units in a development that must be sold or contractually committed to by buyers before a lender will agree to advance funds or allow the loan to progress past a certain stage.

What fees is the lender charging the borrower?

The borrower usually pays the lender’s fees in connection with the facility.  These fees typically include a line fee, an establishment fee, and a management fee.  These fees will either be deducted from the initial advance under the facility or capitalised and paid on the repayment date.

Is there a minimum interest period?

A “minimum interest period” is a provision commonly found in construction loan agreements that sets a floor on the length of time for which interest is calculated on a drawn loan.  In practical terms, it means that even if a borrower repays or prepays a loan very quickly, the lender is entitled to charge interest for at least a specified minimum period.  The minimum interest provisions should be carefully reviewed, as they can represent a material additional cost where the loan is repaid earlier than anticipated.

What warranties is the borrower providing to the lender?

The construction facility agreement will require the borrower to give certain representations and warranties to the lender concerning itself, its affairs, and the project.  These representations and warranties are statements of fact or circumstance upon which the lender will rely in making its decision to advance funds under the facility.

The borrower should review each representation and warranty carefully to ensure that it is able to give it truthfully and without qualification at the time of signing and, where required, on each drawdown date.  Where a representation or warranty cannot be given in its current form, the borrower should seek to negotiate appropriate amendments, qualifications, or carve-outs to ensure that it is not in breach of that representation or warranty from the outset of the facility.

What is the lender’s oversight and monitoring of the loan?

A lender-appointed quantity surveyor is central to construction monitoring.  The quantity surveyor’s initial report will benchmark the approved budget, the works programme and contingency and periodic reports will then endorse drawdowns, track variations, and flag schedule or cost pressures.

The lender’s prior written consent is usually required for:

• variations above certain minimum thresholds;
• material amendments to the building contract;
• consultant appointments; and
• changes to sales documentation (including changes to deposit amounts, assignment rights and sunset clauses).

What are the borrower’s reporting requirements?

The facility will typically require regular borrower reporting, including the delivery of financial statements, sales registers, settlements pipeline, leasing updates for mixed-use schemes and insurance confirmations, together with updated project cash flows.

What are the default provisions?

Construction loans usually contain very broad default provisions.  Events of default will typically encompass:

• non-payment;
• breach of covenants;
• insolvency events;
• termination of critical project documents (such as the building contract);
• construction delays; and
• failure of pre-sales tests and other project-specific defaults, including the insolvency of the builder.

The borrower should seek to negotiate cure periods for breaches and, where appropriate, a review event mechanism rather than automatic default treatment for failure to achieve specified project milestones or to maintain the minimum qualifying pre-sales requirement.

Conclusion

Construction loans are essential to funding property development, but they are equally a tool for managing risk on the part of both borrowers and lenders.  Cost overruns, construction delays, builder insolvency and sales and settlement risk remain among the most significant risks for borrowers.  A thorough understanding of how the facility will operate in practice, coupled with the careful tailoring of the facility agreement to the specific circumstances of the borrower and the project, is essential to the effective management of borrower risk.