A Broken Construction Project and A $750,000 Loss

By Marcus Carter

Case Study: The consequences of skipping a comprehensive construction budget analysis during underwriting.

Recently, a veteran in private money lending agreed to fund a ground-up SFR construction loan in Orange County, California. The property was in a premier neighborhood, with substantial equity and little existing debt. The borrower, though inexperienced and having just inherited the property, claimed he would hire a seasoned builder to handle all the construction. He provided the lender with a “self- prepared” budget he believed would cover all the project construction costs. He explained to the lender that the budget was prepared with a friend who had ample building experience and was familiar with construction. The borrower estimated a 12-month timeline for completion and asserted he and his friend would oversee the contractor and all construction.

The lender, relying heavily on the borrower’s equity and the anticipated in-place value, approved a $2.5 million construction loan. An appraisal affirmed the estimated completion value (ARV), and the deal moved quickly into funding and closing.

Soon after funding the nightmare began, a contractor was hired, and it quickly became apparent that the initial borrower “self-prepared” budget was insufficient to complete this project. The owner worked with the contractor on revising the budget, however, increases in the project scope of work and cost overruns quickly appeared and led to a cascade of change orders and significant line-item increases developed. Costs spiraled out of control, and the budget was changed countless times with the project ultimately stalled at roughly 60% completion. The construction funds from the loan were completely exhausted, and frustration set in with all parties.  The contractor filed a mechanics lien for non-payment of the change orders and cost overruns, and the owner was simply not able or prepared to provide the additional capital to complete the project. The property sat idle with no activity for almost 2 years, and it began to deteriorate as time wore on. The situation culminated in a lawsuit, foreclosure and ultimately a $750,000 lender loss.

What went wrong:

• A Pre- Construction Review of the Budget and Scope of work were Skipped during underwriting, and the lender did not verify whether the construction budget adequately supported the defined scope of work.
• The scope of work, plans and owners self-prepared budget were not cross-checked against the budget provided by the builder, creating a disconnect between what was planned, what was funded, and what was feasible.
• A reliance on the Future Value and inherent equity in the property was the justification for utilizing a borrower self-prepared budget along with other due diligence.

What took place:

• The project encountered catastrophic budget shortfalls, due to the inadequacy of the budget.
• The owner was unable to bring in additional capital to close the funding gap, and the loan was not sufficient to complete the project.
• This resulted in a half-built property, a lawsuit, a foreclosure and a $750,000.00 loss to the lender.

Key insights, takeaways & Best Practices.

1. Budget Reviews: A sound underwriting structure should always be implemented. Lenders should require mandatory pre-construction review or feasibility report for construction loans, regardless of the perceived equity cushion. A Pre- Construction Review and project scope analyses are essential. These assessments identify gaps between budget, scope, schedule, and market conditions before lending proceeds. A concise reconciliation between the builder’s budget and the project scope can reveal shortfalls that would otherwise cause liquidity stress. Ensure that there is Contingency in the budget, at a minimum 10%. Adequate contingencies for cost overruns and schedule slippage must be factored into the structure and funding plan.
2. Site / Draw Inspections. Inspect the progress of your construction project with every draw request. Site inspections provide visual proof of completed work. This helps ensure that lenders are only disbursing funds for completed work and helps to align funding with completed work in place.
3. Disciplined Disbursements / Structural Safeguards: Disbursing funds according to the Line-Item Cost Breakdown is essential. Collecting lien waivers and invoices for all vendors, GC, subcontractors and material suppliers on each draw should be a requirement. Draw payments should always be made directly to GC, Subcontractors and materials suppliers, this provides accountability and transparency and helps to ensure that the funds are going to the right parties.

Conclusion:

Construction loans involve many moving parts and carry more risks than other loan types. A disciplined, consistent approach to budget underwriting, funding, draw management, inspections, and draw disbursement is essential. Adherence to best practices is critical for success in construction lending. When executed correctly—with these simple controls and a measured, disciplined process—construction loans can be an excellent product, helping lenders build long-term, loyal relationships with their borrowers.