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Mitigating construction risk - step-in

The commercial investment market is becoming an increasingly less attractive prospect to lenders, such as banks. This being the case, many UK lenders are beginning to look towards development and developers as a potential source of income.

Developers need to borrow money from banks for a much shorter period than commercial investors, and traditionally generate a better return on those funds. However, banks have traditionally shied away from the greater risk that generates that return as speculative schemes, or schemes by developers lacking the requisite funding are doomed to failure.

However, developers of pre-let quality schemes with a proven track record and the financial ability to stand behind that scheme are a much more secure prospect. This guide looks at how lenders can minimise the risk and reap the rewards that come with funding construction projects.

Step-in rights

In the current economic climate, sourcing funders and customers are arguably the biggest risks to a developer undertaking a new construction project. If these are overcome, then the risks inherent in the construction project itself come to the fore. Assuming the contractor’s agreements and any third-party warranties are sound, the main risk comes in the event of a default by the developer. Depending on the terms of any relevant agreements, a tenant may be able to terminate lease agreements in the event of a default. This will prejudice not only revenue from the project in the form of rental income, but the loss of a high-profile tenant may affect the final value of the scheme itself.

This kind of default, resulting in the tenant terminating its lease agreement, will always be an event entitling the lender to ‘enforce’ under its loan agreement. However, many lenders are now having to look at ways of mitigating their losses before they can enforce the loan agreement and order the developer to repay its borrowings.

When an event arises which entitles a tenant to terminate, the lender should have a right to hear about the event and remedy the developer’s default, cure the breach and secure the income or title before the tenant pulls out.

Any collateral warranties in force between the lender and contractor should entitle the lender to exercise step-in rights. Step-in rights allow the beneficiary of the warranty - in this case, the lender - to literally ‘step in’ and take over the developer’s rights as employer of a building contractor or a professional consultant if the developer commits a serious, unremedied breach of the building contract or the professional appointment.

Typically this means that, if the developer becomes insolvent halfway through a project and breaches the building contract or the professional appointment, the lender may step in and effectively become the developer - paying any sums due, and completing the project.

An ability to step in where necessary in this way will be crucial in convincing a lender to support a development. Historically, developers have treated the lender’s interests as an afterthought. This is not acceptable any more.