A lender's guide about how to avoid mechanics liens taking priority over a construction mortgage.
As a general rule, filing or recording determine the priority of payment for mortgages or other real estate liens in the event of default. Minnesota is a "race" state. Whoever wins the race to the courthouse wins the competition for payment priority. The single most important exception to that general rule is that mechanic's liens can gain priority over a mortgage, even when the mortgage is filed before the mechanic's lien.
The rule for determining priority of a mechanic's lien over a previously filed mortgage is easier to recite than to apply. Mechanic's liens attach and take priority from the time of the first visible improvement to the property and take priority over mortgages filed after the first visible improvement. The key difficulty with this rule is that mechanic's liens can take priority over a mortgage for work done after the filing of the mortgage so long as the first visible improvement occurred prior to filing the mortgage.
The following practices can be used to protect the priority of your construction mortgage and avoid the uncertainty of litigation.
Make sure that no visible work is done on the construction site before closing the mortgage. Often the property owner will start construction before the mortgage is in place. If that is the case, then any work undertaken at any time during construction can take priority over the mortgage. The single best way to protect priority is to make sure that construction does not start until after the loan closes and the mortgage is recorded. To document that fact, take "priority pictures" immediately before closing to show the condition of the construction site and that there were no visible improvements prior to closing and recording. But because property owners commonly start construction before closing their construction loans, you may have to rely on other methods to protect your priority. "Early start" title issues usually require managing disbursements to make sure that all contractors are fully paid and that lien waivers are collected as payments are made.
Sworn Construction Statements
Require the general contractor and the owner prepare and submit periodic sworn construction statements which identify the subcontractors, the projected and actual cost of their work, and whether the contractors were paid in full or in part. Review and compare those statements with attention to two primary details. First, is there enough money in the loan to complete the project. If the statements suggest that the cost of the project will exceed the amount of the loan, either the property owner has to find additional funds or there is a risk that a contractor will not be paid and assert a mechanic's lien. It is best to identify that problem as early as possible. Second, is there any hint that a contractor has not been paid. For example, is there a change in the reported identity of a subcontractor from one construction statement to the next. If so, what happened to the first contractor? Was the first contractor fired and not paid for work completed?
Require that an engineer, architect or construction manager inspect the project to ensure that construction progress is keeping pace with disbursements.
Require the owner and the general contractor sign an indemnity agreement in which they agree to indemnify the lender (or the title company if you purchase construction loan title insurance) for losses sustained by mechanic's liens. This kind of contract gives you an opportunity to press the contractor and the owner to make sure that everybody is paid. Indemnity agreements encourage general contractors and owners to use their superior knowledge about the possibility of a mechanic's lien to protect the lender from a priority problem. It is common that an indemnity agreement is combined with a sworn construction statement in one document.
Periodic Title Examinations Before Disbursement.
Make disbursements on a periodic basis with partial title examinations before each disbursement. Ordinarily you will require a full title exam before closing. Before each disbursement, it is possible to confirm that there are no mechanic's liens filed after the full title exam. That process can identify problems early to give you greater flexibility to manage the problem before it gets out of hand.
Require full or partial lien waivers from each contractor as they are paid. With each lien waiver obtained, the risk to your mortgage is reduced to the extent of the amount of the waiver. So long as all of the contractors and material suppliers are paid, there won't be any mechanic's liens filed. Lien waivers very clearly identify the extent to which the contractors have been paid and they are easier to obtain if you require that you get them as a condition for disbursement and payment. Often a disbursing agent will require lien waivers for the preceding draw before making the next disbursement.
You may choose to require construction loan title insurance to insure against your loss of priority due to mechanic's liens. As each disbursement is made, the title insurer reviews the lien waivers, the sworn construction statements and the chain of title and "writes up" the coverage to the extent of the full amount disbursed to that point. If the property owner intends to seek permanent financing after construction, title insurance for the new loan is then available at a reduced rate. This option may be particularly attractive in residential construction where the homeowner will need title insurance anyway for secondary market financing.
When it comes to construction loans, winning the race to the courthouse is not enough to protect your lien. Winning the race is an extremely important first step but then it's usually necessary to carefully follow those loans through the construction process to make sure that all of the contractors and all of the material suppliers are paid and that proper documentation is collected to support proof of payment. Take priority pictures before closing. The contractor or the property owner should periodically be required to furnish lien waivers, indemnity agreements and sworn construction statements as a condition for disbursement. To the extent that there are likely to be difficulties, these practices give early warning and can put you in a position to protect your priority should a contractor choose to assert a mechanic's lien.
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