This is part of an ongoing series on hospitality financing by Sundip Patel, CEO, AVANA Capital.
Hotel construction loans can be extremely lucrative, but their profitability comes with substantial risk. These projects, which can take up to 24 months to complete, have many variables and moving parts. Lenders need to be meticulous in researching the project and involved in the process from start to finish. Here are 7 critical actions you should take to avoid the pitfalls in hotel construction lending:
- Underwrite the general contractor on the project.Of course you plan to thoroughly vet the borrower and evaluate the location of a hotel project before making a construction loan. But a third layer of underwriting deserves equal scrutiny – the General Contractor.The GC, which on a hotel project is usually a company and not an individual, is central to the success of a construction project. They should have experience, solid financial capacity, excellent references and good insurance.It’s also important that they are local to the project. They need to have a full stable of reliable framers, electricians, plumbers, etc. with whom they have worked in the past.You’ll want to check the company’s references, even if your borrower assures you he has confidence in the GC. You should call owners and banks the GC has worked with in the past and, at a minimum, ask these 10 questions:
- Did they have any mechanics liens filed against them?
- Did they stick to the project schedule?
- Did they come in on budget?
- Did they nickel and dime the borrower?
- Did they have lots of change orders?
- Were they cooperative or combative when questioned?
- Were they detail oriented?
- Did they follow through on commitments?
- Did they have any past litigation?
- Would the owner or bank recommend them to others?
Again, do this research on your own. Do not rely on what the borrower tells you.
- Ask questions pertaining to the construction schedule.Your GC should tell you what other projects they’re handling while working on your hotel. Those projects will be competing for their time.The same issue is true regarding the individual tradespeople. Their commitments to other projects could result in delays for you, despite their best intentions. Develop a master schedule and be clear that you expect it to be honored.
- Use a Cost-Plus Contract with your General Contractor.A Fixed Fee Contract offers limited oversight. It allows the GC to hide costs and create change orders.Instead, use a Cost-Plus with Guaranteed Maximum Price Contract. Also called a Cost Reimbursement Contract, it is an agreement to reimburse the GC for building expenses plus a dollar amount of profit usually stated as a percentage of the contract’s full price. It also includes a maximum guaranteed price, which will cause the GC to be diligent up front in its bidding of the project.The main benefit of this type of contract is that it requires the GC to be 100% transparent regarding all costs and sub-contractor bids.Don’t be timid in assuming oversight responsibilities. As the lender, you are entitled to see as much information as the GC.
- Give fund control to an objective third party.Fund management is one of the most ignored aspects of construction lending. When you don’t use a fund control company, you add significant and unnecessary risk to the project.A fund control company sends inspectors to conduct site visits for you during the construction process and check that the work being billed has been completed.Acting like an escrow agent, the fund control company must approve every invoice and authorize every payment, ensuring you don’t disburse more than the project requires at any one time.
- Assign your own personnel to the project.Hiring a fund control company does not relieve you of your oversight duties. There is no substitute for having personnel on your staff with development experience. They should be able to understand the drawings and be comfortable talking with contractors.You want your own people to visit the construction site and speak with the GC, architect, owner and even the sub-contractors. We recommend conducting a site visit every 45-60 days during a project life cycle to obtain your own assessment of the project risk. Those visits allow you to track project progress and verify that franchise specs are being met.Your people should attend all progress review meetings, whether in person or by phone. And they should work with the GC to evaluate proposals from vendors and tradespeople. Insist on three bids for every line item.A high level of hands-on involvement by knowledgeable people on your staff provides an additional layer of oversight, facilitates communication and prevents minor issues from becoming costly problems.
- Withhold contingency funds until the project has reached at least 50% completion.Keeping tight reins on contingency funds forces the borrower to be fiscally disciplined. If unexpected situations arise that require funding, the borrower is responsible for them until that 50%-60% threshold has been reached.Even after that point, insist that the borrower provide you with proper documentation – contract agreements and invoices – to prove the need for those contingency funds.
- Carry adequate insurance.Hazard insurance is a necessity during a construction project and even after the hotel is open and operating. Most buildings have stick frames, which are susceptible to damage and fire.We recommend getting dollar-for-dollar insurance for at least all hard costs (materials, labor, building, FF&E), and the policy should also include coverage for loss of business.While collecting a claim for a construction fire or other catastrophe can take a long time, insurance is nevertheless the best safeguard for unpredictable tragic events.
Problems in the construction of a hotel can result in expensive lessons. By following the seven guidelines listed above, you can avoid costly mistakes and make hotel loans with confidence.