Construction Loans – the importance of builder due diligence in construction lending

Over the last 24 – 36 months Australia has experienced a number of high-profile builder insolvencies leading to (particularly within Tier 1 and 2 contractors) a concentration of builders and in some geographic markets a withdrawal of all but 1 or 2 players in certain construction sectors. This has reduced the available builder pool, competition and adversely impacted development feasibilities.

The cause of the builder insolvency will be slightly different in each case, however, the sector as a whole has been hit with a combination of factors which has eroded builder profit margins and in some cases has been too much to withstand. Factors have included:

COVID-19 leading to labour shortages and supply chain delays;

Record rainfall (east coast) resulting in substantial project delays;

Rising materials and labour costs;

Long dated fixed price contracts which are unable to be amended to adjust for the rising costs.

Construction costs have somewhat stabilized due to an improved supply chain and increasing labour supply post the depths of COVID-19 combined with the completion of longer dated fixed price contracts. Despite this it remains important as ever to undertake thorough builder due diligence to mitigate the risk of development delays or, worse, non-completion. It is not uncommon for the cost of construction to increase up to 30-40% if a builder is required to be replaced. If a project has to be sold in an incomplete state, the land value may actually be diminished by the partially-completed construction.

Builder due diligence

When assessing a construction loan, a detailed review of the builder’s capabilities and experience is essential to ensure they can successfully complete the project on time and within budget. Key areas of builder due diligence include:

Builder capability and experience in comparable developments	Review the builder’s past projects, especially those similar in scope and complexity, as well as the geographical location as regulations vary by state (e.g. NSW Building Commissioner, QLD’s Security of Payments regulations).
Industry reputation	Evaluate the builder’s standing within the industry. Recommendations from industry participants, including quantity surveyors, can offer insights into the builder’s capability, past performance, and quality of work.
Financial capacity	Assess the financial health and stability of the builder to ensure they can sustain the project financially.
Contract pipeline	Review the builder’s historical and forecast contract pipeline to identify any potential overextension.
Work in progress	Assess the status and profitability of the builder’s current projects to identify if the builder is over-extended and at risk of juggling too many projects simultaneously.
Stop Work or Defect Rectification orders	Search for any stop work or defect rectification orders against the builder. Adverse media content can provide red flags regarding the builder’s reliability.

Thorough builder due diligence as part of the loan assessment process helps identify red flags before committing to the construction loan, and safeguard against unexpected costs and delays.

Corval Avenue Limited ACN 089 265 270 AFSL 238546 (Corval Avenue) is the responsible entity of the Corval Avenue Select Credit Fund ARSN 090 994 326 This document does not contain and should not be taken as containing any financial product advice or financial product recommendations and has been prepared without considering your objectives, financial situation or needs. Before making any decision relating to a Corval Avenue fund, you should obtain and read a copy of the product disclosure statement and target market determination, or other relevant disclosure document for that fund, and consider the appropriateness of the fund to your objectives, financial situation and needs. Past performance is not a reliable indicator of future performance. Corval Avenue does not guarantee the accuracy, reliability, or completeness of the information in this document. To the fullest extent permitted by law, Corval Avenue, its group companies, and their directors, officers, employees, consultants, and agents disclaim all liability for any direct or indirect loss or damage arising from the use of this document. All investments carry risk, and the repayment of capital and performance in any of the funds named in this document are not guaranteed.