FINANCING OF CONSTRUCTION PROJECTS

1. FINANCING OF CONSTRUCTION PROJECTS

2. LIMITED AND PERSONAL LIABILITY • CREDIT FINANCING FOR CONSTRUCTION • Qualifications for Credit • Financing Construction by Credit • Term Loans and Standby Credit • Construction Loans • Latent Credit • Cost of Credit • Time of Credit • Cash Flow in Construction

3. LIMITED AND PERSONAL LIABILITY • Construction produces an expensive and durable asset that requires a large investment. Therefore, almost every project requires capital in amounts larger than most owners can provide, and so most owner-developers and governments borrow. • In construction, lenders become the financial partners of those who borrow, while surety companies become the guarantors of contractors’ performance. • The strengths and weaknesses of the companies that borrow are therefore of vital concern to a lender and surety company. Should a contractor fail, a lender or a surety company might be obliged to take over a construction contract or development project.

4. LIMITED AND PERSONAL LIABILITY (cont.) • Incorporation ensures that the owners of a corporation are liable for the liabilities of the corporation only to the extent of their investment in it. • Simply put, given the nature and risks of construction, those who deal with construction companies seek to protect themselves against losses that they might otherwise incur because of limited liability.

5. CREDIT FINANCING FOR CONSTRUCTION • Contractors need loans to bridge the gap between doing work and getting paid for it. • Credit implies three fundamental things: • Capital: used for making wealth • Time: or the duration of a loan • Return: the interest or profit on a loan • For a builder, credit is often short term (less than a year), or medium term (a few years). It is usually job overhead cost. • For a developer, it is often longer (e.g. a mortgage for a term of years)

6. QUALIFICATIONS FOR CREDIT • Besides stability, credit requires three C’s from the borrower: • Character (person’s credit rating) • Capacity to repay (ability to repay a loan, current financial status) • Collateral to secure a loan (something of value required by a lender to protect the lender against loss should the borrower not make repayments as agreed - - e.g. for real-property development, the land; for short-term loan, company’s assets) • If one or more of the three Cs appear deficient, the lender may still make the loan, but at a higher rate, since it is at a greater risk.

7. TERM LOANS AND STANDBY CREDIT The many kinds of credit available include: • Revolving credit: A line of credit for more than a year, during which time the borrower pays a fee on the daily average of the unused portion of the credit. It allows the borrower to terminate the credit and reduce the amount of credit available when the original amount is no longer needed. (Typically used for financing construction.) • Standby credit: Similar to revolving, but the borrower cannot repay and borrow again. On completion, the borrower either sells the development or obtains permanent financing.

8. TERM LOANS AND STANDBY CREDIT (cont.) • Serial Term Loans: Obtained by a borrower with revolving or standby credit, terms of which allow a conversion to a serial termloan to be repaid over several years. This provides credit for construction and then a shift to a term loan for such as operating capital to be repaid by income from the new building. • Equipment Leasing: Through a bank and often via a leasing company is another means of construction financing. Cash flow in construction and its variability is the primary cause of the need for most construction financing.

9. FINANCIAL INSTITUTIONS • As a borrower’s partner, a financer needs to know the reason for a loan and how it will be repaid; therefore a loan officer wants to see from a construction company the following financial documents: • Balance sheet • Income (Profit and loss) statement • Retained earnings account reconciliation • Source and application of funds statement • Detailed cost estimate for a project.

10. CONSTRUCTION LOANS • Construction is project-oriented, complex, and often lenders hire a construction consultant to verify a bid and contract, to monitor a project and its finances, all to protect the lender’s investment. • In other words, a lender seeks assurance from an independent expert that a project is on a sound contractual and financial basis and that it is safe for the lender to have an interest in the development to the extent of the loan. • Besides these assurances, lender will also require an independent appraisal of the completed project, so that if there is a default on the loan the lender will have sufficient equity to cover the loan by a safe margin.

11. LATENT CREDIT • Besides financing by direct credit, there is also a form of internal, short-term, latent credit that regularly helps to finance construction projects. • It is provided by everyone employed on a project: designer, designer’s consultants, construction manager, cost consultants, contractors, subcontractors, suppliers, and the workers.

12. COST OF CREDIT • Cost of credit for a builder is an overhead cost; it depends on an interest rate and loan duration. • Administrative costs (e.g., costs to process a loan, to arrange a line of credit) increase proportionately as the amount of a loan and its term decrease; I.e., the processing costs of small, short-term loans is proportionately higher.

13. TIME OF CREDIT • For a borrower, time affects the cost of credit, but timing also is important. • Timely certification and payment in a construction contract is a primary obligation of the designer and owner. • Late payments to a contractor create a burden for him and for all who depend on his payments. • Many contracts now contain provisions for the payment of interest on an owner’s overdue payments, as any delay creates an extra cost for a payee.

14. CASH FLOW IN CONSTRUCTION • Every contract is a promise to perform, and every construction contract is a promise to pay for work completed. • Cash flow is critical. Like irrigation water, cash flows through a project to all who do work and provide materials and services. • Cash flow requirements are an essential part of project scheduling, and often a lender or his cost consultant wants to examine a cash-flow schedule before approving a loan.