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Diligence Series: Construction Loans

There are many different types of loans you can make with a self-directed IRA or Solo 401(k). Lending to developers or their contracted purchaser for new home development is a popular option.

Many developers prefer to work with private lenders on these projects. If you do a little networking, it can be easy to locate these types of opportunities.

Because construction loans carry a few additional risk factors and are generally somewhat short term, they aren’t a favorite product for many banks.

When banks will lend for new construction, they often introduce so much paperwork complexity and additional fee layers that it can make the loans somewhat undesirable for builders.

Therein lies the opportunity: As a private lender using your IRA, you can be easier to work with. You can even charge a slightly higher interest rate in exchange for simplicity.

To a builder, time is money. The last thing they want to do is spend hours at a bank.

Easy to work with does not, however, mean that you should issue a big check out of your IRA just because you happen to like a builder you know. Lending for new construction requires proper diligence to ensure you minimize risk and maximize the chance of a favorable outcome.

Start with a Good Attorney

While it’s always important to have legal counsel to keep you on the right track and look out for your interests, this becomes an especially important consideration in specialty lending transactions such as for construction loans.

If you don’t have an attorney with specialty knowledge in this field in your list of contacts, reach out to title companies or attorneys. They’ll know who in your community knows what they’re doing, since they end up recording the notes.

Know the Builder

Whether your borrower is the builder or the homeowner who is hiring the builder on their behalf, no one person has more impact on the success or failure of a development project than the builder.

Be sure to evaluate the track record and level of experience the builder has. Have them provide a portfolio of completed projects and outline whether they were finished on time and on budget or experienced difficulties.

In some cases, you may be able to corroborate the facts with title records for the subject properties. A background check is never a bad idea and is relatively easy to obtain.

It’s also important that the builder can exhibit proficiency in dealing with the local municipality. Are they familiar with the application and permitting processes? Do they have a realistic vision of the time impact that code compliance will have on the project?

In some regions, you may be able to see if they have code violations on prior projects.

Licensing and Insurance

You’ll want to make sure that the builder as well as any potential sub-contractors carry the appropriate licensing and insurance for the project. Don’t just ask, but require that policies be presented as part of the loan underwriting review.

Evaluate the Project

Any time your IRA or 401(k) is lending money, it is critical to understand what the underlying security for the loan is. In a new construction loan, that can be a moving target.

At first there may only be an unpermitted plot of land. Will infrastructure such as roads and utilities be in place before the loan is issued, or is site development part of the project?

Infrastructure takes time and money. Whether your loan includes capital for that purpose or not, the project does not move forward until site work is complete. Be sure you understand where the project you are lending on begins.

It’s important to review the project plan and ensure that it’s reasonable with respect to timing, and how the various phases of construction will fall in place. The more you know about how homes are built, the better you’ll be able to validate a plan.

If you’re not an expert, perhaps having an experienced 3rd party look over a plan will be to your benefit. With a builder who has plenty of relevant history building in a specific community, checking their work on the plan may be less critical.

Think about potential obstacles and contingencies. What happens if there are delays with permitting or due to weather? If framing scheduled to take place in May gets pushed to June, will the roofing sub-contractor still be available, or will an alternate need to be found?

It’s perhaps unrealistic to expect a builder to have answers for every possible contingency. What’s important is to see that they realistically expect obstacles to pop up and have experience minimizing the impact of such problems.

Of course, the dollars have to make sense, too. It should be pretty easy to determine the build cost per square foot of similar projects.

The potential selling price of the finished home should also be something you can evaluate and verify within reason. Do the numbers add up? Is there a reasonable profit for the builder in place, even if delays occur?

Note Design

With new construction finance, the terms of a note are generally more complex than other lending arrangements. It’s important to ensure you have a solid contract that protects your interests at various stages, and ensures measurable goals are met before capital is released in appropriate stages.

Again, the importance of having a quality attorney help in this area cannot be understated.

Some of the concepts that can be unique to construction lending include:

Performance Bonds or Guarantees

  • Such bonding should be a standard part of a construction loan.
  • You want to ensure that the lender guarantees completion and cannot simply walk off the job.
  • Likewise, you may want to see a payment bond in place that requires all subcontractors and materials suppliers to be paid even if the contractor fails to do so.
  • This reduces your potential exposure to claims from those ancillary parties in the event of project failure.

Staged Payments with Appropriate Terms

  • In most construction lending arrangements, funds are released to the borrower in phases, once completion of certain milestones are met.
  • How many such stages will be appropriate and what level of funding should be released at each stage is variable depending on the nature and scope of the project.
  • What you as a lender want to ensure is that you release enough funds to allow the builder to keep moving forward efficiently, but not so much as to create unnecessary exposure.
  • In some larger projects, it may be appropriate to document payment to subcontractors and have them issue a partial lien release.
  • You also want to make sure there is a reasonable amount of time between the builder’s statement of completion of a project phase and a requirement to deliver the next round of funding.
  • It will be necessary to verify completion and execute a funding transaction, all of which takes time.

Retainage

  • A good lending contract will retain some of the borrower’s payments until major milestones are met.
  • This tactic helps to drive the contractor to complete the project in a complete and professional manner.
  • One might withhold 10% until the project is half-way done and then 5% until the project is fully completed and signed off on.

Reserves

  • The capital being lent should only be part of the builder’s overall project cost.
  • You may want to specify that the builder demonstrate a certain amount of liquid reserves and verify the continued availability of such reserves over the course of the project.
  • With a performance bond, this may not be necessary.

Completion Deadline & Damages for Failure to Complete

  • In some types of construction projects, it may be appropriate to establish a deadline and a penalty paid by the builder for failure to complete the project by that date.
  • Such language is often used in larger commercial projects where income to the lender/property owner does not start generating until project completion.
  • Each day a project goes unfinished therefore represents a cost in terms of revenue lost.
  • For construction of a residence, this may not be as much of a day-to-day factor but could be looked at in terms of months beyond scheduled completion.

Terms of Completion

  • Be sure the loan contract specifically outlines what both parties view as completion of the project.
  • The last thing you want to have happen is a situation where the developer thinks they are done and should be paid in full, but the property has necessary components unfinished.
  • Clarity on this point before starting can reduce a lot of potential headache.

Recording and Servicing

  • In order to be truly enforceable, a note must be recorded.
  • You should never make a loan from your self-directed retirement plan without having it documented with the local county records office.
  • For simple notes with less complex terms, it’s possible to self-administer the loan. With larger and more complex contracts, it can be beneficial to have a 3rd party servicing company handle the note and ensure the contract is adhered to.

Acting as a construction lender can be a good way to generate above-average returns in short to mid-term projects. The overall risk-reward-liquidity balance can be favorable.

The best way to obtain a minimum amount of risk is to perform proper diligence on the project and the note contract itself. And remember, when your self-directed IRA requires the use of an attorney, the cost of those legal services should be paid by the plan, not by you.

It’s often appropriate to include such legal costs as part of up-front loan fees paid by the borrower.

Discover more on real estate due diligence with your self-directed IRA »

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