How to Manage Your Risk with Contractor Acceptance (6 Steps)

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Consumer construction lending is quickly becoming the mortgage industry's most sought after loan product.  Every GSE and agency has a consumer-related construction loan product available  and they are growing in popularity due to consumer demand, talent recruiting, and attractiveness in the secondary mortgage market.  So whether you're talking about new construction or renovation, lenders are excited about the new wave of construction lending.

These construction loan products are nothing new to the industry, but many of these programs are undergoing major overhauls to meet the growing urgency of the national housing shortage.  There's no doubt that construction lending has inherent risks and potential pitfalls but much of this can be avoided by simply following industry best practices and developing processes that incorporate good pre-closing risk management.

Make sure your contractor measures up before they break ground.

Construction lending takes on many different forms, but for purposes of this article, I will be referencing consumer construction loans specifically, like the Fannie Mae or USDA Single-Close construction to perm loans, which is made to the consumer (borrower) and gives them the ability to choose a General Contractor to build their home.  

The borrower selecting their own General Contractor presents a level of unknown risk to the lender since the lender has not qualified the contractor, and the success of a completed project is dependent on the contractor completing the home on time and on budget. This risk can be mitigated with a review process known as Contractor Acceptance - not to be confused with  contractor “approval” since the lender is not approving the contractor.  

Relying on word-of-mouth referrals or online reviews isn’t enough. Finding a trustworthy contractor takes thorough research and a sound contractor acceptance review process. Here are six simple steps to follow:  

1. Gather Information

Every construction loan should have contractor acceptance review performed.  Providing well-documented information to the borrower and contractor during the application process  will allow all parties to know how the loan program works, what role the lender plays, and how the contractor will get paid. This is a great time to provide the contractor with a “Contractor Questionnaire” so they can prepare the necessary documents and authorize the review process.  

2. Check References  

The contractor should provide a series of references to support his qualifications.  Past customers, trade, supplier and banking references should be contacted.  Look for experience, track record, strong relationships, and credit capacity.  Remember, the contractor will need to fund day-to-day operations so make sure he or she has positive credit terms.  Its recommended to even review the contractor's tax returns or bank statements to confirm the contractor has a viable business with positive cash flow.

Be on the lookout for these red flags when checking on references:

  • Past customers don’t return calls or did not have positive experiences.
  • Contractor has sub-contractors that have not done business with them.
  • Contractor did not complete any new home builds for past customer references or specializes in renovation.  

3. Trust but Verify

Verify the contractor's license with the state contractors board or local entity that oversees the process. Not all jurisdictions have a licensing process, so do your due diligence to verify that the contractor is properly licensed in the jurisdiction of the proposed project. Contact the issuing agency of the contractor's general liability insurance policy to verify that it is still active in the amounts shown on the declaration page. 

It is also best practice to make sure that the contractor is in good standing with the secretary of state and that the contractor, or, his business entity, are not listed on the OFAC sanctions database.  It is smart to run a background check on both the contractor and his business. Be on the lookout for liens, judgments, bankruptcies and criminal activity.  All of these issues could potentially cause problems in completing the project and are indicators of the contractor's track record.  

4. Get to Know the Contractor

Even experienced construction lenders tend to overlook this critical step. After you have gathered all the information from the review process, schedule some time to speak to the contractor. I can't stress how important this simple step may be and how much you can learn in a 15 minute call.

It is also a great opportunity to discuss the details of your program and gain insight from the contractor's perspective. Contractors will have questions about your loan program and how the draws, disbursements, and inspection processes work.  

5. Gather Feedback and Track Performance

It's a common misconception that the Contractor Acceptance process ends after the contractor has been accepted. It is now time to monitor the contractor's performance by gathering feedback from borrowers and tracking the contractor's performance through the construction process. The Construction Loan Manager by Land Gorilla allows lenders to gather this feedback with rating systems, activity monitoring, and contractor document tracking. A good construction program is built with good risk management that is efficient and can scale effortlessly.

6. Making the Decision

The contractor acceptance process should bring potential red flags to the surface and allow the lender to make an overall decision to “accept” or “not-accept” the contractor that was chosen by the borrower. The final review process should also be performed by someone independent of the transaction and not compensated by commission or production bonuses. 

Remember, it's OK to say no and pass on a contractor, it will be worth it in the long run.

A quality Contractor Acceptance review process is necessary for any lender originating consumer construction loans and a well run program must have a documented risk management policy that outlines these processes. Staying inside your risk profile produces consistency and outlines a clear path to success. The results will be a successful program with borrowers having a positive experience getting their homes completed.  The reputation risk is positive when dealing with qualified contractors and happy borrowers - both of which are more likely to recommend your program to others.