Mitigating construction risk - step-in

Out-Law Guide | 04 Aug 2011 | 10:53 am | 1 min. read

This guide was last updated in August 2011.

Lenders are experiencing increasing financial pressures in the commercial investment market through a mixture of lenders from foreign markets, funds, foreign buyers and insurance companies. Many UK lenders are now turning their attention to development and developers, with a proven track record and the financial ability to stand behind a proposed development project, as a more secure source of income.

Development needs to borrow capital from lenders for a much shorter period than investment, and generates better returns. However, lenders have traditionally shied away from the greater risk that generates that return.

Mitigating lender's risk on default

If the market and consumer risk overcomes the hurdles, then the construction risk comes to the fore. Assuming the arrangements made by the contractor are acceptable to the lender, the risk is around whether the contractor or developer will default allowing a tenant to terminate a lease agreement. This prejudices revenue, as well as impacting on the value of the property.

Default and termination will always be an event which entitles the lender to enforce its loan agreement and claim back what it has lent. Many lenders now have to look at mitigating this risk before enforcement. Banks lend – they are not property developers and do not like to develop.

Well-drafted agreements for lease, headlease building agreements or building licences should be careful to ensure that the lender's financial interest is protected.

If an event arises which entitles a tenant, the head landlord or the person granting the licence to terminate that agreement, the lender should have a right to hear about and then remedy that default, cure the breach and secure the income or title.

Where there is a contractor or consultant default that does or could lead to that event, collateral warranties – which give a third party rights in a contract entered into between other parties - should entitle the development lender to exercise step-in rights. Where the borrower is in breach of its obligations under the loan agreement, the lender should be able to pro-actively step into the development documentation, building contract and consultant appointments.

Conclusion

Giving the lender the ability to step in and remedy defaults along the line will be crucial in convincing it to support a development project. Historically, developers have treated the lender's interests as an afterthought. This will not be acceptable in the current market.