Article by John Hutmacher, ©2006 Blake, Cassels & Graydon LLP
This article was originally published in Blakes Bulletin on Real Estate, March 2006
Lenders taking security on Canadian real estate have to consider a number of special factors where construction of the project in respect of which the security is being granted has not yet commenced or where construction will not be complete prior to the advance of funds.
While many of the features of construction loans are similar to those arising for completed real estate projects, there are also important differences. Some of these differences, and the steps that lenders should take to deal with the risks they create, are described below.
Feasibility of Project
If funds are being borrowed to enable a borrower to complete the construction of improvements, the lender will want to know whether the project is feasible, given the funds available. Are the loan proceeds, together with equity contributions from the borrower, sufficient to complete the project as budgeted? Does the construction budget represent a realistic estimate of the costs to complete the project? The lender must undertake a careful review, often with the help of expert consultants, of the borrower’s construction budget and the plans and specifications for the proposed improvements, all with a view to confirming that sufficient funds will be available to complete the project as contemplated.
Cost to Complete Basis
Once the lender is satisfied that the project is feasible within the parameters of an approved budget, it will usually require that the loan funds be advanced in stages, in a series of separate advances, based upon the progress of completion of construction. This is to ensure that the loan funds being advanced closely match the construction costs being incurred. At the time of each advance, the lender will require that the borrower deliver a written draw request in a prescribed form, confirming the amount of loan funds requested and attaching copies of invoices from contractors to whom the loan funds will be disbursed. In the draw request, the borrower will also be required to certify that, based upon the latest estimates, the aggregate amount of loan funds advanced, together with the unadvanced portion of the loan, will be sufficient to complete the project in accordance with the approved budget and plans. The lender and its consultants will keep a close eye on project expenses in relation to the approved budget and will always want to be satisfied that the undrawn portion of the loan is sufficient to pay the costs to complete the project. If there are any shortfalls, the borrower will be called upon to contribute additional funds to bring the amounts into equilibrium.
Priority of Security
Since construction may be ongoing for a lengthy period of time, steps will also have to be taken to protect the priority of the lender’s mortgage security to the full extent of all funds advanced. On the date of the initial advance of funds, the borrower’s lawyers will be required to deliver a title opinion confirming the priority of the mortgage security as of that date. On the dates of subsequent advances, the title opinion will have to be updated to confirm that the security continues to have the required priority with respect to each subsequent advance.
Lenders also have to be particularly concerned with the existence of construction liens. As a general rule, no funds should be advanced in the face of a construction lien registered against title to the property, and any liens should be vacated or discharged before subsequent advances occur. In Ontario, construction liens registered after the date of a loan advance can "shelter" under the priority of any unvacated liens that existed at the time of the advance. Thus, by advancing funds in the face of a construction lien, lenders run the risk of losing priority for the amount of the advance not just to existing registered lien claimants, but to all those capable of subsequently sheltering under the unvacated lien. Accordingly, lenders inevitably insist that any construction liens be vacated before making loan advances, since holdbacks, undertakings and other devices do not provide adequate protection for the lender. Fortunately, in Ontario, construction liens can be vacated quickly and borrowers have a court mechanism available to them for posting alternative security for the claim, while freeing title from the lien.
In addition to the real and personal property security documents commonly obtained for non-construction loans, construction lenders frequently obtain additional security unique to the fact that the project being secured is under construction. One such item of additional security is an assignment of material contracts pertaining to the construction, including all building and construction contracts, plans and permits. This will enable the lender to complete the project with the existing team of contractors and suppliers if the lender is forced to realize on its security. Depending upon the corporate structure of the borrower, it may also be appropriate to obtain a completion guarantee from a principal or parent company of the borrower.
Insurance requirements are different for projects under construction than for completed projects. The borrower will be required to take out builders "all risk" insurance, which provides for enhanced coverage for buildings under construction. Depending on the size of the project, it may also be appropriate to require that the borrower’s contractors obtain specified insurance coverage and that the borrower’s architect and engineers have errors and omissions coverage in place.
The foregoing represents only a brief summary of some of the issues arising with respect to construction loans. In consultation with legal counsel, lenders can take a number of steps to ensure that their interests are best protected, notwithstanding that the underlying real estate asset is under construction.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.