A construction loan is a type of short-term financing to fund a new construction project. If you’re planning to construct a multi-family home, apartment building, high-rise, commercial office building, or another type of large project, you will probably consider obtaining a commercial construction loan.
Commercial construction loans are different from other loans. Most loans are structured so the borrower receives the full amount they are requesting upfront. Then, once the loan is received, the borrower makes payments over a set period of time.
However, with construction loans, the borrower does not receive the full amount upfront. Instead, you’ll work with the lender to create what is known as a draw schedule. This means that you will receive payments from the lender as your project hits new milestones. For example, the first draw might be used for the clearing and developing the land. The next draw you receive may be provided when the foundation is poured and another when the framing is complete, and so on.
Typically, a lender will require a confirmation from an inspector that your project has hit each new milestone before releasing the next draw. This process will continue until all milestones have been completed and you have received the full amount.
When you take out a construction loan, you will only pay interest on the portion of the loan proceeds that you have received. Therefore, if the total loan amount is $600,000, but the lender has only lent you $150,000, you will pay interest on the $150,000.
Once the project is done and the full amount is due, what should you do next? Instead of making one large payment, you can look into a commercial mortgage. The property will likely serve as collateral for the mortgage, and you can use the lump sum from the mortgage to pay off the commercial construction loan.
Commercial construction loan process
1. Connect with a lender
Contact a hard money lender or traditional lender to discuss your project and find out what financing guidelines and solutions they have.
2. Commercial construction loan underwriting
After you submit your loan application, the lender will quickly evaluate the application internally to make a decision on whether or not to proceed. During this review, the lender is looking at the project cost, summary projections, underlying assumptions, and background of the developers. If the project is one the lender would like to move forward with, they will sometimes provide you with a loan term sheet. The term sheet typically outlines the terms and conditions of the loan, provided all the information that was provided is accurate and reasonable. Once the term sheet has been reviewed and accepted, the lender will move to full underwriting and approval of the proposed loan.
During the underwriting process, the lender compiles more detailed information about the project. Expect the lender to request building plans, general contractors’ bids, cost projections, construction timelines, etc. It’s also typical for a lender to ask for the borrowers’ tax returns, financial statements, and any other documents that can support the loan request.
One of the biggest differences between a commercial construction loan and investment real estate loan, from an underwriting standpoint, is that a construction loan has no operating history to underwrite. Therefore, the valuation of the property is only based on the real estate pro forma. As for the credit approval process, it’s similar to other commercial loans, but due to the extra risks involved, the development team, general contractor, and market conditions are all reviewed in more depth.
After the loan has been approved, the lender will provide a commitment letter. This is similar to the term sheet but is a legally binding contract, whereas the term sheet is non-binding.
3. Loan agreement and closing
Once you’ve committed, you’ll be provided with a closing checklist which outlines in detail what needs to be completed prior to the loan closing and funding to begin. As mentioned, additional funds are distributed on based on a draw schedule for the costs incurred in each stage.
Typical construction loan rates and requirements
Interest rates and fees vary greatly but generally increase as a direct correlation to leverage or risk. The higher the leverage or risk to the lender, the higher the cost to the borrower. Factors such as borrower creditworthiness, liquidity, and experience, also play into the cost of capital.
3 – 6% interest
Fund 50 – 75% of project cost (“Loan-to-cost” or “LTC”)
60 – 90-days to fund, typically
Strict financial, experience, and credit requirements, underwrite covenants, and prepayment penalties
Usually have additional deposit requirements and concentration limits for markets and asset classes, or for particular borrowers
Modifying or changing construction loan terms mid-way through with a traditional lender can be difficult or impossible
Private and hard money lenders:
7 – 14% interest
75 – 90%+ LTC, requiring much less cash at closing (“down payments”) to fund than conventional lenders
Broadmark Realty Capital, for example, will typically fund between 80 – 90% of project costs and can use the land as equity
Much more relaxed liquidity, net worth, experience, and credit requirements
15 – 60-days to fund, typically
Broadmark Realty Capital, for example, is able to close within 1-2 weeks on most project types from the time appraisal is received (larger loans may take longer)
No deposit requirements and will rarely have covenants
Broadmark Realty Capital, for example, rarely underwrites covenants or prepayment penalties and has no deposit requirements
While conventional lenders may have lower interest rates, they also have lower leverage (requiring you to have more cash and equity), more difficult and longer approval and closing processes, and strings attached. Private and hard money lenders have higher interest rates but lend more towards the project’s costs, requiring you to contribute less cash upfront, making loans easier to qualify, faster to close, and have fewer strings attached.
Types of commercial construction loans
There are a few different scenarios in which developers and investors can use commercial construction financing solutions. These include land development, vertical construction, and acquisition and development projects.
Commercial construction loans can become complex and tough to secure. However, understanding how they are evaluated by lenders can help clarify the funding process. Broadmark Realty Capital has specialized in commercial construction loans and real estate development loans since 2010. Whether you’re looking for financing or have questions, call one of our loan specialists today!