Participants in construction loan transactions should be prepared for new title underwriting guidelines.
If you are engaged in real estate development or construction, or in related financing transactions, you are probably familiar with the term “priority break.” A priority break can occur when a general contractor or any of its subcontractors start to work on a project before a construction mortgage is recorded, triggering the possibility of the filing of mechanics’ liens by the general contractor and by every subcontractor on the project.
Consider this common example: A fencing subcontractor starts work on a project before checking with the general contractor to determine whether the construction loan has been recorded. The result is a classic priority break that plagues the entire project, because under Arizona law every subcontractor now has lien rights prior to the lien of the construction lender, regardless of when each subcontractor actually performs its work on the project.
The title company closing the financing deal and insuring the lender’s lien will notice the work when it inspects on the day before or on the morning of the loan closing. At that point, the title company informs the deal participants, who then scramble to find solutions to the broken priority issue. Possible approaches to this problem may include personal guarantees, bonding, indemnity agreements, letters of credit, etc., some combination of which may allow the title company to insure the first position of the construction lender. However, to the extent that these approaches are available at all, they are usually time consuming and can delay the funding of the construction loan.
In our experience, until recently a simple drive-by performed by the title company (and perhaps a representative of the lender) will obviate the issue: no construction, no priority break. However, it has come to our attention that several of the major title companies doing business in Arizona have been directed by their national underwriting groups to treat every construction loan as a potential priority break scenario, requiring the types of approaches discussed above, even when there is not an actual priority break.