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BSCi 7100 – Executive Issues in Construction

Class Meeting Notes

Financial Issues in Regard to Running a Construction Company

Banking Issues – Construction Loans, Starting a Construction Company

Date:                             Tuesday, November 28, 2000 beginning at 5:00 P.M.

Re:                                 Class discussion with future guest lecturer Jerry Coleman, Head of the Commercial Lending Department at SunTrust Bank in Columbus Georgia 

General

The general outline of this class session encompassed a question and answer session with Mr. Coleman based on a list of topics the class is developed at its November 14 meeting.  These questions deal mainly with issues involving the bank load a new contractor would need to start up his construction business.

Mr. Jerry Coleman is the Head of the Commercial Lending Department of SunTrust Bank in Columbus Georgia. His department works with $5,000,000.00 and higher loans of all commercial types, including development loans and construction loans. Most of these loans are with developers. Commercial contractors seldom need large loans because the nature of their business results in their receiving their money from the owner of the building they are constructing. Any “start up money” they would need would normally be built into their contract with the owner.

SunTrust Bank was formerly Trust Company Bank. The name was changed a few years after Trust purchased Sun Bank in Florida and Third National Bank in Tennessee. SunTrust is now the 10^th largest bank in the country with 90 billion dollars in assets. Florida was chosen for expansion mainly because of the number of wealth retirees moving to Florida, resulting in a large volume of deposits for the bank to lend. This high volume improves the amount of profit obtained from the spread between deposit interest and loan interest. There are 5 markets in Florida with deposits higher than the entire state of Alabama.

Question One – What does a prospective new General Contractor need to bring to the banker to improve his chances of receiving a start up loan, establish a credit line, or look attractive as a business venture?

Cash is King – The contractor needs to have cash or other personal assets, such as stock or property, to show he is serious about his new venture. If he has no cash, then his chances are very slim, if not impossible. The banker wants to see that you have the capital to weather bad times and economic downturns. The bank will most likely put a lien on the assets (collateral) to prevent divestiture of them by the person wanting the loan.

Business Plan – A business plan is good, but all of them usually look good. The banker is not an expert on running a business.  As long as the idea is not too new or far fetched, the plan if presented well, will not have that much impact on the loan approval.

Question Two – What kind of loan can a Residential/Light Commercial Contractor expect to receive from the bank to build a spec home?

How much money the builder can receive depends partly on market conditions in the area. If the spec housing market is booming and the spec house can expect to be sold before it is finished, a loan is more likely than if there are a large number of completed spec houses still up for sale. Typically the builder can get a two-year construction loan. At some point the builder will have start making payments on the loan. At the end of the two years he will most likely have to turn the house over to the bank as payment. Banks are not good realtors and do not like to have to do this. Also, banks will usually finance only up to 70 percent of the appraised value of the spec home. An appraiser hired by the bank determines the appraised value. The person wanting the loan will foot the bill for this appraisal. A builder just starting out is better off starting with a contract house where he has an owner who pays him. He can then probably get a line of credit based on a letter of approval form the owner’s mortgage company.

Question Three – What kind of loan can a Residential/Light Commercial Contractor expect to receive from the bank for a $100,000.00 start up loan for light commercial work?

This would be tougher than a residential loan. The market for this type of work is much narrower. Spec commercial buildings are very risky. Most commercial work is contract work with the owner of the building paying the contractor. The contractor would have to build his start-up costs into the cost of the project. A bank would not be likely to grant a loan for this project. At the very least, the contractor would have to have collateral equal to the value of the project and provide a personal guarantee as the owner of the construction company.

Question Four – One of the contractors that came to talk to the class mentioned having three different kinds of accounts with the bank: a money market account, a deposit account, and a zero balance check writing account.  Could you explain how these work?

The three accounts together work as a money management system to provide the account holder with the best return on his money. The deposit account holds the money deposited on that day, helping with record keeping. The money is transferred to the money market account at the end of the day, so it can begin providing value as soon as possible. Checks are written off of the check writing account, providing records of checks cashed each day. At the end of the day, money is transferred from the money market account to the check writing account to cover the amount of the checks. The result is that as much money as possible stays in the money market account where it provides a return to the account holder.

Question Five – What is the key to a contractor being successful?

Liquidity is important. One job can take a contractor down A contractor must have the cash necessary to carry him through the bad projects, which will happen. The construction industry is a litigious profession. You have the owner vs. the contractor vs. the architect vs. the sub-contractor vs. the supplier. Each wants to put the blame for problems on someone else. This makes construction a very risky business.

Bonding capacity is also key to the success of a contractor. The money a contractor needs to complete a project is paid by the owner of the project. The contractor must have the bonding capacity to cover the cost of the project if something goes wrong. The bonding company actually shares the risk with the contractor. The most a contractor will need a loan for is related to timing issues. The contractor may need a two or three week loan just to carry him until he receives the next payment from the owner. If the contractor is borrowing for a longer period of time, the bank will consider it a sign that something is wrong with the company.  The bonding company almost always requires the contractor to have an established line of credit with a bank.  The amount of this line of credit is based on liquidity, cash, bonding capacity, and project backlog.  The bank will more than likely base its approval on the recommendation of the bonding company. If the bonding company says Ok, the loan will be ok. If the bonding company hems and haws, the bank will not extend the line of credit to the contractor. The contractor can not hide from the bonding company. It will most likely know more about the contractor’s financial situation, from the contractor’s audit (% of completion) books and his tax (completed projects) books, than he does.

Question Six – If a contractor wanted to start a development project, say Game Day Condominiums in Auburn, where would he start to get development money from the bank?

A bank looks at two types of risk when deciding on whether or not to finance a project. These two types are credit risk and construction risk.

Credit Risk includes an evaluation of the following and similar issues regarding the developer:

·         Developer’s history of getting paid

·         Number of pre-sold units (would need to be 60 percent or better)

·         Developer capacity

·         Developer’s history with similar projects

·         The whole picture (similar projects in area and elsewhere, current market conditions, etc.)

·         Developer’s tax returns for the previous three years

·         Personal financial statements

·         Rent Roles

·         Projections (Smell test by bank or consultant of worst case market conditions vs. developer’s estimate)

·         Developer’s experience

·         Developer’s credentials

Construction Risk includes an evaluation of the following and similar issues regarding the project:

• Can it be done in budget?
• Who is the contractor and what is his reputation?
• Who is the bonding company and what is its reputation?

All projects over $750,000.00 brought to the bank for a development loan will get an automatic construction risk review. The developer will be required to provide plans, specifications, and a cost breakdown for the project. The bank will have a third party consultant conduct a cost and feasibility study to help the bank decide whether or not to grant the loan. This third party will be a construction expert, usually a construction manager or an architect, who specializes as a consultant. If the loan is approved, this same consultant will also do monthly inspections of the project while it is under construction to protect the banks interests. The borrower will be expected to pay all of the related costs.

In establishing construction lending, the banks goals are as follows:

·         Recognize and limit the bank’s risk

·         Maintain the bank’s lending policies

·         Accept only reasonable risk

·         Document the construction transaction

·         Protection from third parties

The bank also wants to protect itself from the following risks:

·         Insufficient money to complete

·         Subs not paid – mechanics liens

·         Inadequate workmanship or materials (devaluing of the project)

To protect itself the bank will require third party inspections (in addition to any inspections by the architect of record). The bank will expect copies of all pay requests accompanied by letters of lien waiver by those being paid. This is in addition to the normal paperwork that is part of a contract project. The developer will be expected to pay all these additional cost. He is the one making the big profits, and as such should be the one taking on the financial responsibility.

Question Seven – What documents will a developer or owner have to have when applying for a loan?

·         Construction contract

·         Plans, specifications, and cost breakdown (for third party review)

·         Soils report and compaction test

·         Permits

·         Bonds and Insurance

·         Procedures and loan budget

·         Payment requisitions and lien affidavits (bank form) – required for each draw, usually monthly

·         Inspection reports (by Bank’s consultant and architect of record)

·         Disbursement tracking record

Banks usually have a loan officer who specializes in construction loans. He will most likely have a degree in finance, but will have enough experience to understand construction specific items such as plans and specs. He will make use of his construction consultant for those items he does not understand.

All loans and conditions are negotiable, but a loan officer needs to be 99.5% correct in his loan approvals for the bank to remain profitable, due to the low amount of the spread between deposits and loans. If the banker follows all the steps and procedures, but the loan defaults due to unforeseen circumstances, he can probably keep his job. If he skips steps and the loan defaults, he will most likely be given the boot.

Closing Comments

Banks are in the business of lending money. They want to lend you money if possible, but not if the risk, in their view, is too great. Normally the bank will recoup its loses if a business fails by foreclosing on the collateral, but if the company files for bankruptcy, the bank can lose big time. The bank is taking a risk, which it wants to minimize. The bank wants you to succeed, but does not want to set you up for failure. If the bank denies you the loan, it is not saying you won’t be successful. It is just saying it does not want to take the risk. Do not take it personally, or let it deter you from your goal.

One of the biggest mistakes companies that fail have made is not reinvesting in the company.  It is tempting, when the money starts rolling in, for the owner to buy that house or car he has always wanted. You need to make sure to allow for continued growth of the company and to make allowances for the hard times that all companies experience at one point or another.

The key indicators for evaluating future market potential are:

·         Residential Inventory – Number of new homes on the market (Higher than two years ago.)

·         Number of New Mortgages and Refinances (Down from two years ago.)

·         Stock Market (Downward corrections, like now, result in less liquidity and thus fewer new projects)

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