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Church Loan Approval and 5 Danger Zones for Managing Risk

Managing risk in preparation for a church's loan approval takes savvy and careful planning.

Here is some solid advice that is worth sharing for any church planning a building project. The construction process has and always will have its challenges.

First, economic realities have affected the collection plate, which has lowered operating income and significantly affected capital campaigns designed to raise money for upcoming projects.

Second, finding quality builders in a financial position to handle your project may be more difficult as the recession has hit the construction industry particularly hard.

And third, financial institutions are more reluctant to offer construction loans;even to church borrowers, who have been traditionally considered less risky than other commercial organizations. And those who do offer these loans are more selective on the organizations and projects they are willing to consider.

Churches wanting to build now need to put themselves in an optimal position for consideration of a construction loan.

They must understand from the lenders point of view the things that add risk to the construction loan, and what lenders will typically look for to mitigate that risk. Because construction loans contain both a financial risk component (risk of payment default), and construction risk component (project completion risk), the church’s ability to manage risk becomes paramount.

If the church can show they understand these risks and have taken steps to mitigate them, a lender will be more likely to approve their loan request.

Here are five risk areas, let’s call them Danger Zones that churches should consider shoring up prior to their loan request.

Danger Zone #1: Project Delivery. Avoid Dealing Directly with Subcontractors

Project Delivery refers to the method or system of organizing the design and construction of the facility to be built. The American Institute of Architects (AIA) notes that contractual responsibility and the legal/contractual relationship between parties is the key concept for differentiating between project delivery methods. [Several of the] most common project delivery methods, [historically] are Design-Bid-Build, Design-Build, and Construction Manager at Risk.

Design-Bid-Build is the traditional process where the owner contracts with an architect to design the project, and solicits bids from general contractors based on the design plans. The best bid is chosen and the general contractor contracts with the owner to build the project for a lump sum cost. The general contractor hires subcontractors, and the architect typically administers the construction contract helping the owner manage the project.

In Design-Build, the owner contracts with a Design-Build firm [that] delivers both the design and the construction of the project for a specified cost. Like the general contractor, the Design-Build firm also hires the subcontractors.

In Construction Manager at Risk, a construction manager is hired by the owner, typically advising the owner throughout the design process, and then becoming the general contractor through a Guaranteed Maximum Price contract, and hiring the subcontractors. The owner contracts separately with the architect.

All of these delivery methods are typically acceptable to most lenders, and have certain protections inherent in them for owners.

The most important protection is that a firm has contracted to deliver the project at a specified or maximum price, and that this firm has the contractual relationships with the subcontractors. That way, if there is a problem with the subcontractor, the firm can step in and take care of the problem, and the liability lies with the firm, and not the owner.

Beware of project delivery scenarios that require the church to directly contract with subcontractors. This is referred to as Owner-Builder project delivery, and the owners basically act as their own general contractors.

There can be perceived cost savings with this approach, and it can seem particularly attractive to churches that may be on a tight budget in terms of money available to complete a project, or for churches wanting to build more for less. With Owner-Builder projects, since there is no general contractor, there is no need to build the contractors profit into the project costs.

This is significant, because that profit is typically in the 10 percent range. So Owner-Builder projects have the potential to cost less.

However, there is a reason that the General Contractor or Design-Build firm charges 10 perent. It’s because they are taking on the risk and liability of supervising the work of the subcontractors, and ultimately paying for any costs that might arise out of the subcontractor issues.

In addition, workers compensation and liability risks that are taken on by general contractors and Design-Build firms must now be taken on by the church in this scenario, creating additional risk.

Ultimately, the biggest risk for an Owner-Builder is that any cost overruns or legal liability is taken on by the owner rather than the builder. All of the risk has shifted to the church. Most lenders will not loan an Owner-Builder project, regardless of how financially strong the church is.

Even projects managed by a Construction Manager have the potential to be Owner-Builder. It is common for construction managers to recommend the church to contract directly with the subcontractors, but the construction manager will agree to stay on to manage the project.

This is called Construction Manager as Agent, but is really Owner-Builder in disguise, unless the contract specifically promises to deliver the project at a specified price, and explicitly spells out the construction manager’s relationships with the subcontractors. If a construction manager recommends this project delivery, it is a sign that they do not want to or aren’t financially able to take the risk of delivering the project at a specified price. Since Construction Manager as Agent is basically an Owner-Builder project, most lenders will not loan on this project delivery, as well.

Danger Zone #2: Lack of Contingency
A second danger zone is lack of contingency built into the project.

Contingency refers to a dollar amount set aside in the cost estimate for costs related to unforeseen circumstances in the construction process. This amount can vary based on a variety of factors, including the complexity and size of the project. Note that contingency is not an amount set aside for change orders initiated by the church, like upgrading the flooring, but rather for change orders necessitated by issues during construction; for example, encountering soil issues during grading as a result of unseasonably wet weather.

Construction projects rarely go as planned, so a healthy contingency is critical to reducing the construction risk of the project.

Keep in mind that most lenders will monitor the church’s funds during a project. If, at any time during the project, the cost to complete is greater than the sum of the church’s cash contribution and the remaining amount of the loan, the lender may halt disbursements to the project until the deficit is corrected. If contingency runs out, and further unforeseen changes continue to escalate the cost of the project, the church runs the risk of having the project stopped in the middle of construction by the lender.

A prudent lender, then, will require a significant contingency. Ten percent is a rule of thumb for the project. If [an] adequate contingency is not in the cost estimates, the lender may require the difference between the minimum requirement and what is shown in the estimate to be deposited into a captive account at the lender. Making sure there is adequate contingency either in the cost estimate or set aside as additional borrower contribution will put the church in a better position for the lender to say yes to the loan.

Danger Zone #3: No Payment and Performance Bonds
There are a variety of risk factors that contribute to the risk of a project not being built to completion. One significant factor is the general contractor’s financial health.

What happens when the general contractor goes belly up during a project and declares bankruptcy?

It does not matter how iron clad the church’s contract with the GC is if the GC can no longer afford to pay their subcontractors or purchase materials for the project.

Payment and performance bonds, a type of surety bond, are an insurance product designed to protect the owner against the failure of the general contractor in the middle of a project.

In the event of the failure of a general contractor to perform on the contract, performance bonds pay the church, up to the amount of the bond, as compensation for the loss, allowing them to use the funds to complete the project. Payment bonds compensate the church if the contractor fails to pay subcontractors and suppliers.

Many contractors will try to convince churches that they don’t need these bonds for a project, and that bonds merely raise the cost of the project.

Bonds do raise the initial cost of a project, typically from 1 percent to 5 percent, depending on the market for bonds at the time, and the strength of the contractor obtaining the bond.

Since the contractor merely passes the cost of the bond to the church, why would the contractor recommend the church not take this prudent step to protect itself? One possible reason is that the contractor doesn’t financially qualify for the bonds.

Another reason is that although the contractor may have bonding capacity, that capacity is at its limits, meaning that they can’t cover this project until they finish another project of the same size.

Either way, the church may want to consider partnering with a contractor who has the ability to provide payment and performance bonds for the project. If the contractor for your project cannot provide payment and performance bonds, then your lender may be hesitant to loan on the project.

Danger Zone #4: Broken Lien Priority

As a part of the construction process, all the parties that are contracted to work on the property or supply materials to the property have the right to file mechanics liens on the property to ensure that they are paid for the work or materials supplied to the project.

When they are hired they will typically file a notice that documents their right to file that lien. When the work is done and they are paid what they are owed, they will then file a lien release. When a lender provides a construction loan, it is with the understanding that they will be in first lien position, and that mechanics liens are filed after the lender’s lien, meaning that the lender will have first priority in legally moving on the collateral to collect their debt in case the borrower defaults. Then those who filed mechanics liens would have secondary rights to the collateral if they were not paid.

Sometimes, when churches have a substantial amount of cash contribution into the project, they will start the project, thinking they will pay the initial portions of the project with their own cash, figuring that they will finalize their loan when the funds are actually needed to finish the project.

The problem is that as soon as any work begins on the property, the mechanics lien rights for those firms working start the day they set foot on the property, regardless of whether they actually file the lien or not. This creates what is called broken lien priority, and the title company will no longer be able to issue a title policy to insure first lien position to the lender.

Even the most innocuous contractor activity can lead to broken priority. Merely putting up a chain link fence around a property, bringing a trailer on the property, or even storing tools somewhere on the property constitutes beginning the project.

The title company will physically inspect the property just prior to the deed recording to look for evidence of broken lien priority.

If lien priority is broken, the title company will require an indemnity agreement from the borrower, which holds the title company harmless against liens arising from the broken priority.

The indemnity agreement process used to be a fairly straightforward process of assessing the church’s ability to manage the risk of dealing with these liens, but now it is a much more difficult process, and there is no guarantee the title company will approve the indemnity agreement. Many lenders will now not consider loans where the construction has started and there is broken lien priority.

Danger Zone #5: Progress Payment Planning, Retainage, and Cash Management
The typical construction loan progress payment process has a lot of moving parts.

Sometimes the lender’s process for their due diligence on the progress payments does not correlate well with the payment progress terms of the contract between the church and contractor. For example, most lenders, when they receive the approved progress payment request from the borrower, will then schedule an inspection by an in-house or third-party inspector.

The inspector will make sure from the lender’s perspective that all the amount of work billed is commensurate with the amount of work finished, and that the work was done according to the plans.

The lender will review the supporting documentation, including lien releases, and make sure there is adequate cash and remaining loan proceeds to fully fund the project. This process can take a few weeks. When these few weeks are added to the time it takes for the church to approve and submit the payment request to the lender, it can take around 30 days to get the contractor paid for the work done.

The typical time frame for required payments to contractors is 30 days, but that is not always the case, as this time frame is negotiated in the contract. If it is less than 30 days, this can create legal problems, unless the church has sufficient cash to float the payment to the contractor while waiting to get reimbursed.

Another issue is that the contractor, church, and lender may not always agree that the amount of work billed is commensurate with what is actually done. When the amount billed is significantly greater than the work actually done, this is known as overbilling.

Overbilling is so common in the industry that a certain amount of it is almost expected. There are a lot of reasons for it; most notable is that by billing ahead of the work, the contractor is trying to use the church’s or lender’s capital to replace their own capital outlay in the project, thus shifting risk from them to the church or lender.

Whatever the reason may be, the lender will typically have little tolerance for the overbilling, and will approve progress payments only within a small variance of what they think is appropriate. The church will then need to negotiate with the contractor for a smaller progress payment.

Since they have typically already signed the payment certification, this can be a problem. In order to resolve the situation, the church may have to make up the difference with its own cash.

Finally, the issue of retainage (sometimes called retention) can create progress payment issues as well.

Retainage is an amount that is held back from each progress payment to insure that all mechanics liens are released when the project is finished. Retainage typically runs between 5 percent and 10 percent. The more retention held, the more incentive a contractor has to get the liens released, and the greater cash requirement for the contractor, because they still have to pay the subcontractors in full.

Lenders also typically require some significant amount of retainage to be held from their disbursements throughout the project and some amount to be held until the lien period expires (the lien period is the time period where all parties involved in the construction of the project have the right to file a mechanics lien).

After lien period expiration, the lender then receives an endorsement indicating they have clear title, free of mechanics’ liens. This lien period can vary from state to state, but typically runs 60 to 90 days. Here is the rub: Most construction contracts require retainage be released to the contractor in 30 days, so there is a 30-day or more gap between when the lender releases the remaining loan funds to the church and the church is required to pay the contractor the retainage.

In addition, the lender’s requirement for retainage might be different than what is in the contract.

So throughout the project, the lender may be holding more money back than what is specified in the contract, causing the church to be required to add more of its own funds to the progress payments to the contractor. At the end of the lien period these amounts are reimbursed when the lender’s retainage is released, but the higher cash requirement is still there during construction.

What is the take-away from all of this?

Because of the nature of the construction progress payment process, the cash requirements of the construction project are likely to be higher than most churches anticipate. Because of this, lenders will look very carefully at a church’s cash position, and will likely require significantly more cash reserves on a construction loan than a traditional loan. The church will need to plan accordingly.

Bring in Your Lender Early in the Process. In summary, here are a few things a church can do to mitigate the risks from these danger zones and position themselves for financing:
Use traditional project delivery, with lump sum or guaranteed maximum price contracts, avoiding direct relationships with subcontractors
Have adequate contingency imbedded in the project costs
Protect the project with payment and performance bonds
Don’t begin construction until the loan is funded
Don’t plan on beginning a project until significant additional cash reserves have been set aside for progress payment and retainage issues

The five danger zones covered here are only some of the many pitfalls that await churches in their journey to constructing their [facilities].

The construction process is very fluid, and requires expertise throughout. Many churches realize this and seek wisdom from people experienced in commercial construction from the very start of the process. It is also important to navigate the financing requirements as early as possible, and to allow those experts on the financing side to collaborate with those on the construction side.

The reward is a smoother construction project, less risk, and a beautiful, completed building.

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