Commercial construction appears poised to further accelerate in 2014, as the business outlook continues to improve. A building owner, having completed the necessary due diligence for a construction project, naturally wants to begin construction immediately. Owners who are financing the construction through a loan should be cautious, however, before allowing a contractor to begin work at the site prior to the loan closing. If construction begins before the loan closes, the owner could face higher title insurance premiums, increased financial disclosures, and delays in construction funding.
Lenders will typically require as a condition to closing, a loan title policy insuring the validity and priority of the lender’s mortgage (a “loan policy”) and several endorsements to the loan policy, possibly including a mechanic’s lien endorsement. If the lender, rather than an escrow agent, will be advancing the loan proceeds, the premium for a mechanic’s lien endorsement (ALTA Form 32), so long as construction does not commence prior to the filing of the mortgage, will be 25% of the amount of the premium for the loan policy or $500.00, whichever is greater. If the owner purchases an owner’s policy to protect the owner’s title, the premium to remove the general exception for mechanic’s lien from the owner’s policy will be 10% of the premium for the owner’s policy, or $250.00, whichever is greater, if construction has not already begun.
On the other hand, if prior to both the mortgage and a notice of commencement being filed, work began or materials were dropped off at the site (“Pre-Start Work”), the premium to remove the general exception for mechanic’s liens in the loan policy, or in the owner’s policy, would be 40% of the amount of the premium for the respective policy or $500.00, whichever is greater. For a multi-million dollar commercial construction project, the increase in the cost of title insurance caused by the Pre-Start Work could be substantial.
As an example of Pre-Start Work, the owner could have authorized an excavator to begin digging before the loan closes. If the excavator has provided a “notice of furnishing” to the owner but is not fully paid for the excavation, the excavator could file a mechanic’s lien against the project site for the unpaid amount of the excavator’s contract. The excavator’s lien would have lien priority over the mortgage and all subsequently filed mechanic’s liens against the site. If the lender forecloses its mortgage, or if a mechanic’s lien holder (including the excavator) forecloses its lien, the excavator would be paid the full amount of his or her mechanic’s lien before any sale proceeds would be paid to the lender on its mortgage or to any other holder of a mechanic’s lien.
When asked to remove the general exception for mechanic’s liens from the loan policy, with Pre-Start Work present, the title company will usually consult with its underwriter to obtain authorization to remove the exception. The underwriter will probably impose additional requirements on the owner and the general contractor as conditions to removing the exception. Those requirements may include:
(a) A general contractor’s sworn statement, in which the general contractor describes the Pre-Start Work, names all subcontractors and material suppliers that furnished Pre-Start Work, and indicates the amount paid to each of them;
(b) An unconditional lien waiver from each subcontractor and material supplier that furnished Pre-Start Work, waiving lien rights to the extent of all money paid to them as of the date of the loan closing;
(c) An indemnity agreement signed by the owner, indemnifying the title company for all claims on the loan policy related to mechanic’s liens; the title company may also require a co-indemnitor if the owner has insufficient assets to support the indemnity; and
(d) Audited financial statements for the owner and each co-indemnitor.
Given the substantial increase in the premium for the loan policy and the owner’s policy, the likely delay in closing the loan caused by the title company obtaining its underwriter’s approval to remove the mechanic’s lien exception, and the financial disclosures and indemnity required of the owner, all caused by the presence of Pre-Start Work at the project site, an owner should not allow the commencement of construction until after the loan closes.
Donald E. Miehls
Walter | Haverfield LLP
sec> <heading></heading> <para> </para> </sec>