Funds Control for Real Estate Investors with BuildZig #575

John Bohannon

This week Bruce Norris is joined by John Bohannon of BuildZig who offers funds control for real estate investors doing new construction projects and large fix and flip projects. John took his first interest in shop class for the construction industry at large in elementary school and has turned it into a career. He is the director of business development at BuildZig, a funds control firm that has been in the industry since 1936. John is a licensed general contractor, certified construction inspector, registered home inspector, and a certified review appraiser.

Episode Highlights

  • What is funds control?
  • What does a funds control company do?
  • Who uses funds control?
  • What are the costs involved?
  • What does the funds control process look like from the borrower perspective?
  • How quickly should they expect to get paid?
  • Does funds control monitor quality? Legality? Proper building?

Episode Notes

Aaron started by asking John how long he had been in the construction industry. He said it was pretty much all his life. Even in high school he would work in construction over the summer to make extra money. He also did it throughout high school and into when he graduated college. Shortly after this, he became involved with BuildZig, which at the time was called Builder’s Control.

BuildZig is a little bit more than funds control. They actually do their own projects as well. They are very active in their corporate office in the Bay Area, mostly the East Bay. However, they are involved in San Francisco and are opening an office in the North Bay to help the fire victims in Santa Rosa and Napa. They are interested in under-utilized properties, and the adaptive reuse has become their specialty. For example, an old mansion sat abandoned for years in the Oakland Hills area. It had probably sat empty for a long time since it had some historic qualifications. Therefore, they could not rip it down or change the façade too much. They were able to find a way to turn it and preserve the historical qualities. Taking under-utilized properties and creating value is their biggest project with which they are involved.

Aaron asked if it is unusual for a funds control company to also be developing their own projects. John said he is not aware of any others, although Aaron said he does not see it as a huge asset. John in a way feels the pain; and he said there is nothing like actually building and having current pricing, contract concerns, changes in mechanic lien law, and being actively involved in the day-to-day building makes you a better funds control company.

Aaron said you are certainly more in tune with the process. He asked John if BuildZig is only in California, but John said they are nationwide. Aaron said there are a lot of rules and regulations to follow construction in Northern California alone depending on what city you are in is a whole new ball of wax let alone a historic property. John said as far as California, it seems to always be leading the edge of new changes in law. Being in California puts them in a good position to see what trends are in laws. It was probably happening with him first, and he was the case study.

Aaron and John went on to discuss their main topic: funds control. He wondered if the proper pronunciation is plural: funds control. John said it is, and it is the way to do incremental financing for construction loans. What this really comes down to is they have to trace their heritage back to the Great Depression. Right after this, construction lenders were unwilling to take the risk to do construction loans. That, in part, was due to before the Great Depression people asking how much they needed to go build the house. They were then given the money to go build that house. It was not a highly regulated loan.

After the Great Depression, things were feeling very uncomfortable in the way of money for an asset that had not reached its full value. The idea of incremental financing popped up with both Venture and Bank of America in 1936. The idea was to commit to the loan to build the house, but they would only release the funds as they increased the value of the property by improving it. They had the loan commitment, so then they just had to go out to pour the foundation and the funds control company would go verify the foundation was done. After this, the bank would release the funds. The idea was that you would release money commiserate to the improvement value of the property. You are never giving the money ahead of increased value. Projects are finished, dollars are released, and your loan that might be 65% LTV may come underwater. This is funds control.

Aaron does not think some people appreciate how after the downturn that SB 978 actually became law. Any rehab or flip that is over $100,000 in repairs or is a ground-up construction must come under funds control. SB 978 was created, and one legislator decided that all hard money lenders were to blame for the Great Recession. So, this new law was created. Although there is some merit to it, it says if your construction loan is over $100,000 in improvements you have to fully fund that loan the full amount up front. You have to put it with an independent third party, someone who is different from the arranging broker or investor who put the money into the deed of trust. That qualified inspection has to be performed to verify the money being released is commiserate with the work being done on site. This is exactly funds control.

John next went on to address why so many builders had a construction loan before 2008. They were built; then all of a sudden they go for a draw request to the construction lender and are told by the lender they do not have the money. You cannot find a single investor to put any money in even though they committed to the full loan amount. What happens next is you get mechanics liens on the job site, properties getting into a legal battle, no one was getting paid, and no one wanted to touch the property. From that standpoint, SB 978 solved that riddle. If you are going to make a financial commitment to a $1 million construction loan, then you need to raise $1 million at close of escrow.

On the flip side, from day one they put up all the money and can charge interest on the full amount. This may upset a borrower; but if you are that same contractor, you have a great sense of confidence the money is there and you can move forward on your project without hesitation. Your next request after this won’t be funded. It is really a balancing act. No law is perfect, and for the most part they got it down pretty good. This applies to trust deed investments as well. People have tried to get around this by filing for a CFL license, which is like a fund pool. This is not required for SB 978, but the same list can apply to a builder. If they are committed to the amount, they still have to raise that amount. They may not have it on hand, but they would still need to make a draw request.

There is a risk, and Aaron said they do get complaints about this with new construction. Local banks are starting to fund these too, although he does not know if they are funding it a different way as a line of credit instead of actually being a loan. Even before funds control was required, they were doing something very similar in house.

They went on to talk about the process since it is not just about holding the funds in third party. Aaron said he never thought about the other angle when you are facing a downturn and somebody financially committed to you does not have the money. This makes sure all parties are whole from the beginning and the money is actually there. John brings a lot of different skill sets to the table. It is not necessarily the money is sitting in an escrow account when somebody is going out to do the inspection. Aaron asked what the inspectors skill sets are and if he also gets the benefit of their experience knowing what they are looking at. John said the number one goal is to make sure the working request is actually done. Herein lies the difficulty. If a builder submits his request for the foundation and they go out and have a look at it, they will take pictures of it and give an update on it. This makes sense.

The question is whether they did things like compaction, a rebar, a vapor barrier, and the concrete mix all correctly underneath this. All of that duty and responsibility lies with the building department’s special inspectors. John said they have lenders who are usually very experienced who can be on site and take pictures of the job. The reason they do this is they want to verify through the building inspectors signing off on the permit or job card the vocabulary changes depending on which city in which you live. They sign off saying it is to plan the inspection. They can’t say this since they were not there to verify all the things that went underneath the concrete.

A lot of people have the misconception that since inspectors are going out to look at the work that it is being done according to plan and specification. This is not the case. This is the duty and responsibility of the building inspector. They can minimize this by taking photos of the job cards and making sure they have the appropriate government funnel.

On the other side, there is something called a date down. John highly recommended this. It is fairly newer and comes from the title side. If you are a construction lender and have a title company; you want to make sure your construction loan is insured, especially if it is a large amount like $1 million. The title company will tell you they will insure you for this much but apply the date downs during construction. Every time there is a draw request, you will also submit it to the title company who will then run a title check. This is a good risk management tool since at that point in time they can look to see if there are any preliminary notices filed or mechanics or tax liens on the properties. They would also need to check to see if the property taxes have even been paid.

Title companies are ensuring their risk by doing incremental insurance coverage. John said lenders, investors, and the borrower are getting extra protection. It is a check-in because every time money is released, that title is clean and things are moving forward correctly. If, for some reason, something does show up later you have proof along the way that you did what you needed to do and that what showed up was not there prior. This way you make sure the title insurance is covering you.

The idea of mechanics lien laws was to protect contractors from unjust practice. In other words, if they helped improve a property and were not paid, they can file a mechanics lien. This is a cloud on title, just like a tax lien. Therefore, there is a priority. In a normal world, you have your construction lender with a first deed of trust and their first position on title. They have priority; then anything that comes after that is below the other priorities. If you get a mechanics lien five months into the job, you are still priority. The interesting thing that happens is it is a progressive situation. When jobs start falling apart, the experienced contractors are sometimes the fastest to file a mechanics lien since they want to be on top of the list in priority. When you think about the big consumption company that had the cash flow constraints of the small builder and were the first to file the mechanics lien, they know better. He used to think they couldn’t handle it, but they have experience and know better.

Aaron asked if an inspection involves checking to make sure that vendors were paid. John said yes and that the funds control process ensures this. However, the inspection does not necessarily do this. Aaron and John covered holding the funds in a joint control escrow account if you were licensed under the DPO. The other part of it that is very important is that they are collecting invoices and lien releases. Every single draw makes sure lenders are getting paid and that lien releases are getting collected. The foundation will be explored to make sure it is done, then they will receive an invoice from the foundation’s subcontractor that says once you pay a certain amount the mechanics lien rights will be released and paid in full.

During this time, if there was a preliminary notice filed by the rebar supplier and another supplied by the concrete company, they want to make sure they are paid too. When BuildZig gets the invoice, they will tell them they will pay it but ask them where their lien releases are from the material suppliers. This is part of the funds control process that BuildZig does. They want to make sure that everybody who works on the property and supplies the materials for the property is getting paid. You have a general contractor who subs out some work, and if that sub does not pay the cement supplier it will pop up later. This could be a really big number and catch you off guard.

One of the biggest complaints Aaron hears right now for investors is finding qualified labor to do some of the jobs. This is especially true if you are talking about repairs or new construction in the big dollar amount. It is an added insurance policy for sub-standard work as well. It is a permitive process with pictures and an extra set of eyeballs who is used to looking at projects. John said they are an insurance policy for the lender as well. Problems happen, and then a year later you are trying to describe what happened, whether it was a deposition or general sit down. If you show a picture of the foundation proving what happened, then they can release the money. This is your insurance. It works for the borrower, the contractor, and the lender through the whole construction process.

Aaron asked about the process. The way the Norris Group does their construction loans is you need to own the land free and clear and have the permits and plans drawn. The reason they do this is they have a one-year term. If you don’t have the plans and permits, the process could take years depending on what city you are in. The Norris Group only wants to be involved in the construction phase, and you can catch up land value as the construction funds are being released. This is how they accomplish this. Clients come to the Norris Group, fill out a loan application, and then they go to BuildZig if that person qualifies for funds control.

Aaron asked about the process from the borrower perspective and how much control they have when putting together process. John said they start off with the lender and provide an intake for them that the lender then sends to the borrower. They will then ask for a description of the work and their budget as well as the number of requests they think they will require for the loan. They then take the form and provide a personal quote. The reason they do this is in the old days there was just a percentage of construction hold-back. Whatever was charged would presumable cover the funds control fee.

The problem with this is that it is unfair. Good builders who generally have the higher construction loan do not need to do a draw every week. This is similar to what the rehab builders do. A rehab loan for $30,000 is a lot more work than that $1 million loan. If you are an experienced builder and will do 6 draws over the course of the loan, it is unfair to charge you a flat percentage and say “tough.” There is usually a small fee of $500 per draw fee. This draw fee would then include the site inspection and lien leases. This draw package then goes to the lender for final approval.

BuildZig’s contract is between them, the borrower, the contractor, and the lender. They know they would not want any money released from their budget without them knowing, and the borrower would not want the contractor to take any money from that budget without them knowing either. In short, everybody is notified, and the lender is the final one to approve the draw requests. We are all in this together. If you do not want money released and in isolation from any other party, then that’s why you have a draw request. BuildZig has an online system where you can punch in the draw request and sign it via DocuSign. If the contractor submits the draw, it goes to the borrower who then signs it through DocuSign before it is sent off to the lender for approval. This could be reversed if the contractor submits it for approval. They can then send it to the borrower.

Starting this year, they moved everything to online to help improve the process as well as transparency. Everyone is working together to verify invoices and lien releases as well as do a site inspection. It won’t happen in one day, but they will expedite it as quickly as possible. If your draw request is complete with all the invoices and lien releases, then the process will go faster. On average, it takes 3-5 days to turn around the draw request.

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