The more the U.S. housing market changes, which is always, the more lenders face the challenge of making sound credit risk decisions based on new and changing information about the deals, borrowers and builders. Among the many variables, sound risk decisions often depend on how well a new construction lender knows their builders, which is what I call my favorite list of "lessons learned."
The housing market has rejuvenated and flourished somewhat in 2014, with new construction fueling much of the growth and builders popping up in communities hunting for work. Weighing the layers of risk within that growth is what will distinguish an experienced and successful lender. Conversely, the lack of due-diligence performed on a builder prior to closing may leave the lender stuck in a bad place.
To protect your assets lenders must examine the variables surrounding their investment. Based on many years of mortgage lending experience through numerous supply and demand cycles, I recommend three due diligence steps for lenders to help ensure a project is financially feasible and sound.
1. Request clear documentation from the beginning.
Seeing all numbers and liabilities involved up front is critical for lenders to take the next step with confidence on the new construction project. It also establishes the expectation for project communications the lender and builder should both understand and share the desired outcome of the big picture and small details along the way.
2. Be aware of red flags.
When speaking with and registering and/validating the builder, the first few discussions should give lenders a clear indication of whether or not to proceed. Before doing so, lenders should feel comfortable with all answers or follow-up answers. If the comfort isn't there, it could be a sign of instability and uncertainty.
Be cautious of incidents in the builder's past that could signal trouble. For example, low credit scores, bankruptcies and changes to the company name in short period of time, should all lead to follow-up questions from the lender and responses from the builder that exceed satisfaction.
Consider asking the following questions of builders:
Is the builder of record the builder of history? It is important to confirm that the builder in name is the same individual or individuals who contributed to the history of credit, skill and project success. The builder may have the same name with all new individuals working the deal, which is not a clear picture of the risk for lenders.
How long have you worked in this market? The best indication of the builder's credibility is the amount of industry experience. However, be wary of the builder with extensive experience but only stays in one market for one or two years at a time. While this doesn't tell the whole story of the builder, it is certainly a red flag to check out.
How many projects are you currently working on? The builder's typical number of homes is relative to the average price range of the home he/she builds. A builder that builds multi-million dollar homes will build far less than a builder that builds an average unit of $250,000. This should be weighed into what type of portfolio a lender wants to build.
Could you provide me with a detailed budget for the project? A line item cost breakdown should be obtained for every new construction project to 'prove' what costs have been included in the total price. A builder that is not willing provide a line item cost breakdown either hasn't thought through the cost of the project or may be hiding cost in the project, or both.
Can you provide multiple references? The most common argument to obtaining subcontractor and supplier references is "why would a builder ever provide a bad reference?" The reason to ask for a reference is to detect possible issues if the builder provides only one or two references, seems hesitant to provide references, or stumbles through the response.
3. Incorporate professionals.
Traditional lending practices to determine credit worthiness fall in line with checking credit, credit to debt ratios, bank statements, verification of income through tax documentation. There is a wealth of information available today about builders, but this only becomes a valuable decision point when that information is accessible and relevant. A builder's previous history may be the best predictor of his/her future behavior.
In conclusion, at the end of the day, whether the market is hot or not, lenders need to maintain the same diligence about knowing the deal, and the dealer. Knowing the builder means knowing who the dealer is as well as the history of record and the current property numbers. The risk is too great to trust a potential builder's credibility without proper validation. Take these steps to ensure you are more than satisfied with all responses, communication and attention toward you as an invested partner.
Brad Meyer is president of the Trinity Real Estate Solutions family of companies. He founded Trinity Real Estate Solutions in 2003 after spending years in the mortgage lending, financial services, field services, manufacturing and technology industries. Trinity's goal is to provide the banking, lending and insurance industries with a uniquely comprehensive range of residential and commercial products and services designed to mitigate risk. Contact Brad at 888.573.8025 or firstname.lastname@example.org.