Greenbacks for building green: does a lender for sustainable construction projects need to make adjustments to its current practices?

• Author: Prum, Darren A.

1. INTRODUCTION II. CONSTRUCTION LOANS A. Loss Exposures 1. Encumbrances on Real Property a. Theories of Title b. Mechanic's Dens c. Dens on Construction Loans i. Stop Notice or Trapping Statutes ii. Equitable Liens 2. Lender Liability for Activities Beyond the Loan a. Environmental Issues i. Hazardous Waste ii. Environmental Liens B. Acquisition and Attributes 1. Preliminary Underwriting Process 2. Final Underwriting Process a. Construction and Completion Issues b. Permanent Lender Documentation Issues 3. Loan Documents III. LENDER EXPOSURE TO RISKS ON A GREEN BUILDING PROJECT A. Pre-Closing Issues 1. Zoning and Restrictive Covenants 2. Financial Models and Pro-Forma Statements 3. Green Building Standards B. Post Closing Issues 1. Cure and Default 2. Responsible Parties 3. Disbursement Issues IV. MANAGING EXPOSURE ON A GREEN BUILDING CONSTRUCTION LOAN A. Underwriting Process Driven Adjustments 1. Supplemental Application for Green Construction 2. Gathering and Analyzing Green Construction Data B. Document Driven Adjustments 1. Conditions to the Initial Funding of the Loan a. Assignment of Responsibility and Liability b. Assignment of Liability and Government Benefits c. Performance Bonds 2. Disbursement Provisions a. Draw Requirements b. Higher Holdback or Retainage Levels V. CONCLUSION I. INTRODUCTION

   As construction returns to pre-recession levels, lenders will inevitably begin receiving more applications for loans to provide for erecting new buildings. Few real estate developers maintain sufficient funds to secure the resources necessary for construction on their own, so they turn to the lending community to provide interim financing until the completed building receives a permanent loan or mortgage. (1)

   In deciding whether to fund the loan, a lender will conduct an extensive evaluation of the project to determine its viability and to uncover any exposure it might face that would result in a loss. (2) To make a loan possible, the lender will also determine whether mitigation techniques through contractual provisions in the construction loan agreement and disbursement requirements will reduce the perceived risks to acceptable levels. (3)

   In receiving these applications, many lenders will start to see more projects that seek a certified green building because government policies across the country and at all levels now try to encourage private developers to construct certified green structures. (4) However, many lenders fail to recognize that the construction of a green building differs from that of a traditional one. (5) This difference means a lender needs to evaluate its underwriting process to gain better insight as to whether the financial models and pro-forma statements present an accurate picture of its exposure to loss. For those loans deemed worthy of approval, a lender must also consider its mitigation techniques and conditions for disbursement to better address the risks that a green building presents.

   Considering that many lenders will receive applications for construction loans on a green building and will not generally distinguish such projects from traditional ones, the question remains whether adjustments need to occur in the underwriting process and accompanying documents to properly manage and mitigate the risk exposure to acceptable business levels. This Article seeks to address these issues.

   Part II of this Article examines construction loans as applied to traditional building methods. It begins by considering the various loss exposures a lender faces as well as the required processes and documents an applicant will attempt to negotiate in order to obtain the construction loan. With regard to loss exposure, Part II.A explores the risks that confront the mortgage arising from the different theories of title and liens that originate with contractors and material suppliers, as well as liens available against the loan itself. It also evaluates outside activities that can impose liability upon the lender and explains the environmental risks that originate from the dumping of hazardous waste on the land and government repayment programs. Part II.B explains the underwriting process that a lender follows to assess the viability and risk of a traditional construction project, as well as the package of documents and pertinent provisions used to execute the loan.

   Part III considers the unique characteristics, attributes, and risks a green building construction project poses a lender. The first subpart examines green building-specific issues that affect the underwriting process: zoning and restrictive covenants, difficulties associated with the valuation process, and continually evolving business standards. The second subpart sifts through exposures that originate out of cure and default, responsible parties, and disbursement program risks.

   Finally, Part IV responds to the unique risks a green building construction project poses a lender by offering solutions that can mitigate risk exposure to acceptable levels. In malting this proposal, the subparts divide the recommendations between those that affect the underwriting process and those that involve the construction loan documents. The proposals for the underwriting process suggest that lenders capture pertinent-information at the time of the loan application. It then describes methods to better acquire, evaluate, and analyze the financial models and pro-forma statements. Similarly, the recommendations concerning the loan documents offer risk mitigation provisions that address issues prior to and after a lender disburses a green building construction loan.

2. CONSTRUCTION LOANS

   The availability of money to secure construction resources is an important factor for successfully developing private buildings. (6) The construction loan plays a central role in providing funds to make improvements: it fills a financial gap that occurs between the owner's ability to secure permanent financing upon the land with the planned improvements and the land in its current condition. Consequently, a construction loan increases the property's value and better serves owners by eliminating the owners' need to secure all of the financial resources necessary to complete construction at the start of the project. (7)

   Meanwhile, some financial institutions view construction loans as high-risk loans that offer a correspondingly superior reward in return. (8) Because most loans focus on ensuring repayment through initial and alternative sources, the construction lender's concentration is twofold: as the primary assurance, it considers whether the borrower has received commitments that guarantee permanent financing as a means to satisfy the debt obligation; as the backup option, it considers the potential income production of the completed development. (9) Accordingly, some financial institutions believe the loss exposures outweigh the financial rewards; other bankers see construction lending in the opposite light so long as careful steps are taken during the process to minimize risk. (10)

   In conclusion, a construction loan supplies short-term credit to a landowner that does not have all of the funding for its development at the onset. At the same time, it provides the prudent lender an opportunity to attain superior rates of return for assuming such managed risks.

   1. Loss Exposures

      In comparison with lending financed by a completed building, construction lending lacks traditional security for repayment. (11) Construction lenders might find themselves undersecured because construction loans depend on future events to create value. (12) These challenges range from the loss of superior claim rights from mortgage theories and liens to the possible liability for construction defects based upon a lender's involvement during construction. These issues require a discussion prior to considering the new implications created by a green building.

      1. Encumbrances on Real Property

         Since each state government maintains responsibility to develop and operate a recording system for land ownership, courts regularly face the task of recognizing and enforcing ownership and encumbrances on real property within their jurisdiction. (13) In resolving these real property disputes, courts turn to the established recording system of a given jurisdiction to determine the priority order for an encumbrance on a specific parcel of land. (14)

         Depending on the jurisdiction, the recording act will provide guidance as to the priority order for multiple encumbrances and will likely yield different results using the same factual scenario. (15) The different acts offer a compelling incentive to record encumbrances because they assist the courts in establishing priority positions, while taking no direct action against a party that affirmatively or inadvertently fails to follow the statutes. (16) As a result, a party's claim against a given parcel of land may be diminished if it fails to properly and timely record the encumbrance. (17) The unique and potentially numerous encumbrances emanating from a land development project may create unexpected loss exposures for lenders participating in a construction loan.

         a. Theories of Title

         Depending on the mortgage law of a given jurisdiction, the titling and ownership of real property along with the ability to encumber it will vary within the context of a construction project. The main approaches in use today include the Title and Lien Theories of Mortgage Law along with an intermediate method. (18) In jurisdictions following English common law under a Title Theory, the lender does not gain possession, but holds the legal "title" to the real property until the debt is satisfied or foreclosed. (19) Whereas in a Lien Theory jurisdiction, the owner of the land maintains title, while the lender preserves a security interest in the real property and will gain the right to possession after a valid foreclosure occurs. (20) Finally, a few states attempt to find middle...