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A Zero-Risk Loan: The Developer’s Dream

We’ve written two previous blogs on understanding and reducing developer risk, one illustrating the differences between completion guarantees and repayment guarantees, the other covering the full array of bonding mechanisms.

To review, the first article illustrates how completion guarantees offer lower risk for the developer than repayment guarantees. The second points out how bonds can be used to reduce execution risk. These form the foundation of what we see as the ultimate in developer risk mitigation: allow a project’s general contractor (GC) to provide the completion guarantee required by the construction lender. Other than those triggered by bad acts, this completely removes the developer from all construction loan guarantees. It is not zero risk (that’s just a catchy title), but it is a clear move in the right direction.

This is not easily accomplished. And the reasons why it might even be done may not be obvious. Just as the lender seeks assurances from the developer that they will deliver the project through securing a completion guarantee, so too does the developer seek assurances from the general contractor that they will deliver the project through issuance of bonds. The lender wants the developer to guarantee, the developer want the GC to bond. So why not have the lender secure the guarantee from the GC? Easy, right?!?!?

But why would a GC ever provide a completion guarantee?

Unforeseen events come to development projects, regularly. Addressing these challenges is typically the purview of the developer. The GC is a vendor with whom the developer places an order to be fulfilled. A general contractor who steps into the role of a guarantor explicitly accepts possibly unforeseen project risks that may fall well outside the scope of typical order fulfillment. In the traditional GC and developer exchange, “unforeseen” equates to a change in the scope of the GC’s contract, a change order, and a cost increase to offset the additional work; this is simply another order to fulfill. The banks put completion guarantees in place explicitly to deal with the unforeseeable, and costs that don’t fit into the development budget. The scope of the GC’s bonds are limited to the contractual agreement between the developer and general contractor. To take on a completion guarantee, the GC accepts considerably more risk.

So why might they do it?

At the end of the day, it boils down to balancing risk and reward (newsflash). Top GCs have deep expertise in successfully delivering projects on time and on budget and have navigated all of those challenges. They also have an appetite for profit. That’s right, this credit enhancement doesn’t come free. These deals get done when both the profit incentive and the GC’s ability to reduce risks yield a calculus in support of what might otherwise appear to have a lot of downside with very little upside.

Let’s examine some of the fundamental underpinnings to the GC’s go/no-go assessment:

  • Bids (as opposed to budgets) derive only from permitable construction documents; anything less than this level of detail forces a GC to conduct educated guesswork. Once a project secures permits, the full scope of work is very well understood. The experienced contractor knows precisely what’s required to build the project and may perceive the magnitude and array of items which could negatively impact the project’s completion and budget as rather limited.
  • The general contractor almost certainly gains full access to the development budget (not just the construction budget) as part of the guarantee process. They know the explicit and implicit contingencies in their and the developer’s budget that can be requisitioned for unforeseen project costs. (Implicit contingency comes in the form of shifting of line item expenses from overly conservative, or flexible, line item budgets.)
  • Prior to signing loan docs, a wide array of experts including geotechnical, seismic, and civil engineers, lawyers, purchasing agents, subcontractors, cost estimators, and others have richly investigated the project. The intent of all that work is to remove “unforeseen” from the project’s vernacular.
  • Any general contractor who contemplates the guarantee, and who is viewed favorably by the lender as such guarantor, almost certainly has a substantial balance sheet. While they will have zero intention of dipping into that balance sheet, in a worst-case scenario they likely feel that any impairment would be limited.
  • The general contractor likely has rich internal resources for cost controls and risk mitigation including dedicated staff.
  • Frequently, general contractors have very deep and long-standing relationships with their subcontractors. They also often have the upper hand in those relationships. If the project goes sideways and they see material exposure, they tap those relationships for some lower-cost work, even securing it at rates that create a loss for the sub-contractor to be made up later.
  • The general contractor may include project bonding as part of their bid and, depending upon the provisions of the bond, secure a backstop for their own execution and limit their exposure as a guarantor. Additionally, firms that secure strong bonds have been closely scrutinized by the bonding agent and deemed capable of delivery.
  • Often, these deals are institutional. Almost everyone in the transaction brings rich experience and, to a large extent, plays with other people’s money in a fiduciary capacity. These are big kids. While a cursory view of the circumstances might reveal the guarantee as a lopsided risk, only with all eyes wide open and lots of “I” dotting and “t” crossing does this unfold.
  • Finally, and perhaps most importantly, the drive for competitive advantage and profitability within the general contracting field plays into the decision. A GC providing a completion guarantee charges a premium, and may find less resistance to an increase of their typical fees (their margins improve). They might also secure a profits interest in the development. And in a competitive bid scenario, any GC willing to accept some of the project’s downside risk will strongly differentiate itself from the others. The offering of the guarantee is a very robust value proposition.

 

As with most things, there’s another side of this coin. Just because a developer finds a general contractor willing to provide the guarantee doesn’t mean that the contractor can execute the project on time and on budget; nor does it mean the guarantee will provide sufficient incentive for the construction lender to move forward. Further, the project and/or developer (and their equity partner) might not be able to carry the freight associated with the increased costs. With a lot of contractors and developments, the guarantee rightly belongs with the developer.

While asking a general contractor to provide a completion guarantee is easy enough on its face, this is not the easiest piece of business to execute. Often this exchange is reserved for institutional deals between long-standing and experienced contractors and developers. That said, it’s a spectacular arrangement for a developer to successfully orchestrate. Doing so nearly completely eliminates repayment and completion guarantee risk. It is not zero-risk, but it sure is a pretty nice piece of business.