Ground-up construction of a new building carries risk that is distinct from the risk of owning a completed, income-producing property. The Narrow Banking Model removes construction-period debt risk by funding construction with equity, but construction itself remains subject to cost, schedule, and regulatory uncertainty that no financing structure can eliminate.

Cost overruns

Construction budgets are estimates prepared in advance of the work being performed, based on materials pricing, labor availability, and site conditions known at the time the estimate is prepared. Actual construction costs can exceed budgeted costs for reasons including materials price inflation, labor shortages, unforeseen site conditions, and changes to the scope or specification of the building during construction. A material cost overrun can require additional equity capital to complete a project, reduce the return available on the completed asset relative to the return assumed at the outset, or, in a severe case, affect the feasibility of completing the project as originally scoped.

Delays

Construction schedules can be extended by weather, materials or equipment delivery delays, labor availability, contractor performance issues, and permitting or inspection delays. A delayed project generates no rental income during the extension while continuing to incur holding costs. Because the Narrow Banking Model's debt phase begins only once a building is completed and stabilized, a construction delay also postpones the point at which the debt phase and any associated First Secured Mortgage Debenture issuance can begin.

Contractor risk

Construction is performed by third-party general contractors and subcontractors under construction agreements. Contractor performance risk includes the possibility that a contractor becomes insolvent, fails to perform to specification, or is otherwise unable to complete its contracted scope of work. Contractor risk is managed through contractor selection, contract terms, and construction oversight, but it cannot be eliminated: a contractor's financial condition and performance capability are outside the direct control of the investment vehicle.

Zoning and permitting risk

A development site must obtain the zoning classification, building permits, and regulatory approvals required under the applicable municipal, provincial or state, and national regulatory framework before and during construction. Zoning and permitting processes can be lengthy, subject to public consultation, and subject to conditions that are not known with certainty at the time a site is acquired. A zoning or permitting delay, a permitting condition that requires a change to the building's design, or the outright denial of an approval required to proceed can delay a project, increase its cost, or, in a severe case, prevent a specific site from being developed as planned.

Pre-leasing and lease-up risk

The Narrow Banking Model does not require pre-leasing before construction begins — buildings are constructed on an unlevered basis without a pre-leasing condition. This removes pre-leasing as a condition of starting construction, but it does not remove leasing risk from the project: a completed building must still be leased to generate income, and the pace and terms of that lease-up are subject to the market and property risk applicable to the specific location. A building that takes longer than anticipated to lease, or that leases at rents below underwriting assumptions, generates less income during the lease-up period than originally projected, which in turn affects how quickly the property's Interest Coverage Ratio reaches the level required to begin the debt phase.

See also

• about-risks — how risk categories are organized across this wiki
• Narrow Banking Model — the construction and financing sequence referenced above
• market-and-property-risk — leasing and property value risk after construction is complete
• structure-and-regulatory-risk — regulatory risk beyond zoning and permitting