Arguably the most important element of managing a construction loan budget is properly allocating the source of funds (“sources”) for a project and tracking the uses of these funds (“uses”). Proper management of this relationship ensures compliance and protects the lending institution of unnecessary exposure. Let’s begin with a brief description and examples of “sources” and “uses”.
What are "Sources"?
“Sources” are the accounts which fund the construction improvements. In a simple deal it may consist of the borrower’s equity and loan proceeds from the bank. Over the course of the construction project each of these two “sources” will be responsible to pay the bills which are a result of construction. The bank may have pre-defined terms which mandate a contribution ratio from these “sources” or, the equity portion may be necessary for the initial bills followed by funding from the loan. The possible combinations of the payments from the “sources” is endless.
As the complexity of a deal increases, funds from multiple “sources” can be used to develop the project. Examples of these may include multiple borrowers contributing equity from a variety of accounts. A project may have dedicated funds from a bond initiative or may have grant funds to be allocated to the project for specific improvements. These “sources” must be properly accounted and released based upon the terms of the deal.
What are "Uses'?
“Uses” are the specific costs which are paid within a deal. A “use” can be a specific item within a deal or a group of items. For example, a “use” may be as broad as the overall hard cost of construction or be a specific as the cost of a door knob within the project budget. “Uses” are all the line items which are represented in a schedule of values for a project.
Why Projects Experience Funding Issues
We now understand a project is financed through the distribution of payments, sometimes known as a construction draw, which originate from a source of funds and are paid to a “use” or series of “uses”. The concept on the surface is very straight forward and logical. Why then do projects experience funding issues? The answer lies in the attention to detail.
When a project is in its early phases of construction the “sources” of funds are plentiful and the many of the “uses” of these funds have not yet been billed. As a result, when a change order is issued, or a cost over-run is billed, institutions many times differ properly identifying the relationship of the additional cost with a payment source. For example, a roofing line item listed at $100,000 which has not been previously billed experiences change order which is billed in full for $20,000. The funding of this $20,000 is readily processed without question because the balance to complete (available funds) remains very high. The error is only realized when the remaining portion of this line item is billed and suddenly the cost is more than has been allocated.
Proper budget management requires an institution to identify the “source” of every expense which exceeds the original budget. If the project experiences a deductive change of costs, the reduction must also be properly tracked and either transferred to a contingency fund or a reduction in a funding source. Essentially every modification to a budget should balance regardless of the appearance of plentiful budgetary line items. If this simple practice is followed, financial problems are identified early in the process and mitigation can be completed within a reasonable time frame.
The more complex a financial transaction becomes, the more important a standardized practice becomes. In some instances, proving specific funds have been used for specific “uses” is a requirement. Under these scenarios the lending institution must incorporate financial technology solutions which not only track expenditures, but also reports on them. Construction draw management software, like CodeFi’s P360 Solution provides integrated functionality for tracking draw disbursements, inspections, and construction lending and a complete audit trail from billing through disbursement. P360 has built in system controls to prevent erroneous funding and meet regulatory compliance standards.
All “uses” must have a source of funding. The total of the “sources” should never be less than the total of the “uses” otherwise the project is without sufficient funds to complete the work. Any added use of funds must have an equivalent sum added to the source of funding. Diligent and timely tracking of your “sources” and “uses” will prevent the downstream problem of projects lacking sufficient dollars to complete.
Integrating draw management solutions, like P360 help maintain balanced loans throughout the entire construction lifecycle. To learn more about our P360 Solution and other construction loan administration and management solutions, please visit our website at https://www.codefi.com.