Current industry practice makes it problematic for lenders to investigate a builder’s financial situation during construction.

Before contracting with a builder, a developer should undertake financial due diligence aimed at establishing the builder’s capabilities and credit-worthiness. The scope of the due diligence varies in each case because of factors such as:

  • whether a prior relationship exists between the developer and builder
  • the contract value, duration and complexity of the project
  • the lender’s requirements in relation to the financial capacity of the builder

Builder-friendly home building contracts have a standard clause requiring the developer to provide a copy of its loan approval or evidence of cash availability. But there is no requirement for the borrower to satisfy any ongoing financial tests.

Construction contracts that we have seen typically don’t have any ongoing financial reporting requirements, except the need for statutory declarations at each progress claim confirming that all suppliers’ and subcontractors’ payments are up to date. This means that developers must complete their financial due diligence before the building contract is executed.

In all cases development lenders will wish to approve the builder and contract arrangements. The lender will review information sourced by the borrower and will undertake its own enquiries to verify that the builder can complete the development.

After approving the builder, the lender will instruct its lawyer to conduct a legal review of the contract and to prepare a tripartite agreement between the lender, borrower and builder, often referred to as the builder’s tie-in deed. This document is lender-friendly, serving to regulate the conduct of the builder and the borrower. Some key concerns of lenders are that:

  • there are no side agreements
  • the parties will not agree to cumulative variations above an amount determined by the lender’s credit policy
  • the parties will not vary the design, scope and price of the contract without the lender’s consent
  • the parties will not terminate the contract without the lender’s consent.
  • in the event of default, the lender will have the right to step in to the owner’s shoes, rectify the default and instruct the builder to complete the works at the lender’s cost (also a benefit to the builder and really the reason they will sign the deed)

To our knowledge, lenders’ pro forma deeds do not require the builder to provide financial information on request and satisfy ongoing financial requirements during the term of the contract.

In the event of a dispute or if there are significant progress delays the developer and lender may wish to confirm whether the builder is solvent and can complete the project. Delays are often a symptom of a builder suffering financial distress.

Provided the lender is a bank or reputable non-bank lender, a builder can be confident in the lender’s financial capacity. Through the loan documents, the lender will have extensive rights to investigate a borrower’s financial position. However, neither the lender nor the borrower will have similar rights against a builder under current industry practice.

Newpoint Advisory has been highlighting construction risk as a key risk at this point in the property cycle and for some time has been advocating higher standards of builder financial due diligence. The current downturn in market activity (pre-sales and sales of completed stock) will reduce construction activity, increasing competition and providing strong borrowers and lenders a timely opportunity to insist on builders providing ongoing financial information , particularly where the builder is off-program or in default.

Newpoint Advisory recommends that lenders include builder financial covenants in their finance approvals and update their pro forma builder’s tie-in deed.

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