How do construction loans work?

Making sense of commercial construction loans in simple terms

Embarking on a construction project is exciting, but the path to realizing your vision can seem daunting, especially when it comes to financing.

 Knowing how to answer the question “How do construction loans work?” is more relevant than ever for anyone looking to break ground with confidence in 2024.

 This guide aims to peel back the layers of complexity surrounding construction financing, breaking down the essentials into understandable segments. Regardless of your experience level in the construction industry, our objective is to arm you with the knowledge needed to effectively handle the process of securing a construction loan.

 Join us as we build a solid foundation for the successful financing of your construction project.

Explaining construction loans and the construction loan draw schedule

Commercial construction loans are specialized loans designed for construction firms, builders, and developers to finance construction projects, significant renovations, land development, or commercial real estate ventures.

The Associated General Contractors of America (AGC) notes that construction loans are some of the most complex real estate financing options and are deeply connected to the activities of a construction contractor. 

Different from traditional loans, which are issued as a single lump sum, construction loans release funds incrementally, corresponding with the project’s advancement. This method ensures the timely availability of funds for various project needs, from material procurement to labor costs.

 The process starts with the lender and borrower agreeing on a construction loan draw schedule, which outlines specific milestones that, once reached, trigger the release of funds. For example, initial funds might cover pre-construction activities, followed by subsequent releases for phases like groundwork and concrete pouring. Typically, each phase requires an inspection before the next tranche is released. 

During the construction phase, borrowers typically owe only interest on the disbursed amount. Once the project is complete, the loan’s structure generally requires the borrower to repay the principal sum in its entirety. At this point, borrowers often secure a commercial mortgage, using the newly developed property as collateral. This refinancing strategy allows for the construction loan to be cleared, facilitating potentially lower payments spread over a longer term, which can improve cash flow and financial planning for future endeavors.

How do commercial construction loans work?

As outlined in the AGC’s “Guide to Construction Financing,” securing a commercial construction loan involves a bank disbursing funds to a developer for the purpose of project construction. The framework of this loan is outlined in a promissory note, which defines the repayment terms. These terms cover the principal amount, encompassing not only the construction expenses but also the cost of land acquisition and various soft costs such as design fees and financing charges. 

Construction loan interest rates can be fixed, offering a stable annual charge, or variable, adjusting periodically based on specific financial indexes such as the prime rate or LIBOR (London Interbank Offered Rate). This variability allows the loan's interest costs to align with market conditions, offering the developer flexibility in financial planning. 

During the construction phase, the loan's structure is such that the principal typically does not require repayment; instead, interest accumulates, adding to the total amount that will eventually need to be repaid. This accrued interest, known as construction-period interest, ensures that the project can proceed without immediate financial strain from interest payments. 

Upon completion, the construction loan often transitions to permanent financing, marking a shift to a more traditional loan structure with lower interest rates and a longer repayment schedule. This transition is crucial for the financial stability of the project, providing a pathway from the high-risk construction phase to a more sustainable long-term financing solution.

 The loan agreement and accompanying mortgage or deed of trust further secure the loan, providing the lender with a claim on the property as collateral. This legal framework ensures that, in the event of default, the lender can recover the outstanding loan amount through foreclosure, selling the property to the highest bidder. However, the complex nature of construction projects, especially when not fully operational or leased, can present challenges in recovering the full loan amount, highlighting the risk inherent in construction financing. 

Different types of commercial construction loans

Commercial construction projects require a variety of financing options, each tailored to meet the unique needs and stages of development. The Carolina Trust Federal Credit Union outlines several essential types of loans that are prevalent in the industry:

Land development loan

These loans are geared toward financing the purchase and development of raw land. Given the higher risk associated with undeveloped land, these loans often require additional collateral.

Acquisition and development loan

Acquisition and development loans, commonly known as A&D loans, cover the costs of acquiring and preparing land for construction, including any necessary enhancements before construction begins.

Mini-perm loan

Issued post-construction, mini-perm loans provide short-term financing to cover any additional costs incurred. They can help bridge financial gaps until the project becomes self-sustaining.

Takeout loan

Serving as permanent financing, takeout loans replace short-term construction loans. They typically feature lower interest rates and longer repayment terms, easing the financial burden on the project.

Understanding and choosing the right type of loan ensures that you can address the specific financial needs at each stage of your project's development, laying the groundwork for its success and financial health.

SBA loan options

In addition to the above loan options, the U.S. Small Business Administration is a significant source of commercial construction loans, appealing particularly to small business owners due to favorable terms such as lower down payments, competitive interest rates, and manageable credit score requirements.

SBA CDC/504 loan

Tailored for major fixed assets such as real estate, this loan can provide up to $5 million over 10 to 20 years, with interest rates pegged to U.S. Treasury rates. The down payment ranges from 10% to 30%, often requiring collateral and personal guarantees from the business owner. The loan is structured with 40% of project costs financed by an SBA-certified development company (up to $5 million), requiring the borrower to secure another lender for 50% of the costs and contribute at least 10-20% in a down payment.

SBA 7(a) loan

Suitable for the construction or purchase of commercial real estate, this loan features a lending cap of $5 million and a repayment term of up to 25 years. Interest rates are based on the prime rate plus 2.75%, with variations of smaller loans or shorter terms. The down payment for this loan falls between 10% and 20%, with a borrower’s credit score requirement in the high 600s.

 Incorporating SBA loans enhances the possibilities for developers, especially small business owners, by providing accessible, cost-effective solutions for each project phase.

Key players in commercial construction lending

In the commercial construction financing market, several players come together to provide the necessary capital for projects to come to fruition. Understanding who these key players are and their roles can significantly enhance a developer's ability to secure the right kind of funding. Here's an overview of the major participants in commercial construction lending:

Commercial banks

Commercial banks are primary sources of funding in commercial construction lending. They offer a range of loan products tailored to the needs of developers and contractors, emphasizing flexible terms and rates based on project risk and duration. 

Institutional investors

This category includes insurance firms, pension funds, real estate investment trusts (REITs), and government entities, each bringing their own strengths to the table. Insurance companies, with their substantial reserves, are drawn to larger, lower-risk projects that promise stable returns. Meanwhile, pension funds, REITs, and government entities enrich the lending environment by focusing on investments that either yield long-term income or have a substantial community impact.

Mortgage brokers

Mortgage brokers play an intermediary role, connecting developers with the right lenders. They have a deep understanding of the market and can find favorable terms in complex financial environments.

Non-bank lenders

Non-bank lenders offer alternative financing options, often with more flexible criteria and faster processing times. They fill gaps left by traditional banks, especially for projects considered too risky or unconventional.

Typical requirements to obtain a commercial construction loan

Securing a commercial real estate loan involves meeting specific lender requirements beyond those of standard loans. Applicants must go through a detailed preparation and application process. According to the Texas Dow Employees Credit Union (TDECU), key components include:

•  Construction loan down payment: A substantial down payment is typically required to obtain a commercial construction loan. Most lenders mandate at least a 10% down payment of the total project cost, with some requiring up to 30%.
• High business credit score: Typically in the high 600s to low 700s range.
• Acceptable debt service coverage ratio (DSCR): This ratio measures future income against future expenses. A DSCR of 1.25 or higher is often required.
• Appraisal: A professional evaluation of the project's worth and potential return on investment.
• Payment of loan fees: Including processing, documentation, and review fees, among others.
  

How to apply for a commercial construction loan

Applying for a commercial construction loan involves several steps. Here’s a detailed walkthrough:

1.  Preparation of documents: Begin by gathering all necessary documents, including a detailed project plan, financial statements, and any other documents that showcase the viability and potential profitability of the project.
2. Submission of appraisal: Obtain a professional appraisal of the project to determine its potential value and success, which will play an important role in securing the loan.
3. Loan application: Submit your loan application to the lender, ensuring all required paperwork is complete and accurate.
4. Loan underwriting: The lender will review your application during the underwriting process, assessing the risks associated with financing your project.
5. Approval process: If the application meets all criteria, the lender will issue a letter of intent (LOI) outlining the terms of the loan.
6. Closing: The final step involves closing the loan, which includes signing the loan agreement and initiating the funding process based on the construction loan draw schedule. 

Attention to detail and a comprehensive understanding of the lender's requirements are indispensable throughout each stage to ensure a smooth and successful loan application process.

Commercial construction loan interest rates

Construction loan interest rates are influenced by factors like the lender’s policies, market conditions, and the project’s risk level.

 These rates can be fixed, providing stable payment expectations over the loan duration, or variable, adjusting in response to shifts in market benchmarks such as the prime rate or LIBOR. The fluctuating nature of variable rates introduces an element of financial unpredictability, which can impact your project’s budgetary forecasts.

 The TDECU notes that commercial construction loan interest rates typically vary between 4% and 12%. Additionally, the loan-to-value (LTV) ratio plays an important role in determining the feasibility and terms of a loan, reflecting the ratio of the loan amount to the property’s assessed value or purchase price.

Commercial construction loan fees

As mentioned earlier, securing a construction loan comes with its share of fees, ranging from initial application and processing fees to potential penalties for early repayment. Notably, some lenders offer the flexibility to roll these fees into the loan amount, enabling borrowers to spread the cost over the loan’s term and mitigate upfront expenses.

•  Guarantee fees: These fees are levied to cover administrative costs and the expenses associated with issuing mortgage-backed securities.
• Processing fees: Designed to compensate the lender for the expenses involved in processing the loan application.
• Documentation fees: These fees cover the creation of loan documents, with costs varying by lender, typically ranging from $50 to $100.
• Project review fees: Incurred for the lender’s review of the construction plans as part of the loan evaluation process.
• Fund control fees: Applicable if the lender engages a third party to oversee project expenses, ensuring funds are spent efficiently and according to plan.
• Prepayment penalties: Particularly noteworthy, these penalties are imposed for early loan repayment, which could disrupt the lender’s expected profit. The structure of these penalties can be complex, often based on the difference between the original and current interest rates for the remaining term or requiring alternative forms of compensation.

 Understanding the full spectrum of fees associated with a construction loan is extremely important. It not only helps in budgeting and financial planning but also in evaluating the total cost of borrowing. This comprehensive awareness ensures informed decision-making, allowing borrowers to clearly grasp the terms and conditions of their construction loan.

Commercial construction loan down payment

In commercial construction financing, the size of the down payment can help you secure loan approval and favorable terms. Generally, these down payments range from 10% to 30% of the total project cost, directly reflecting the lender’s risk assessment.

 Offering a substantial down payment can significantly mitigate perceived risk from the lender’s perspective, which may, in turn, result in more advantageous interest rates for the borrower.

 Although it’s possible to obtain financing that covers 100% of project costs, these full financing scenarios are uncommon and generally reserved for projects deemed to have exceptionally low risk.

Impact of market trends on construction lending

Market trends can have a significant impact on construction lending, affecting the accessibility and conditions of loans. 

Economic fluctuations, such as changes in GDP growth rates, can sway lenders’ confidence. This dynamic can prompt changes in the interest rates offered on loans and the stringency of underwriting criteria as lenders seek to mitigate risks in uncertain economic climates. 

The real estate market’s shifts in supply and demand also can determine the viability and potential profitability of construction projects. These market movements are important factors that lenders consider when evaluating loan applications, influencing the likelihood of approval. 

Furthermore, interest rate trends determined by central banks directly affect the cost of borrowing. Increases or decreases in these rates can significantly alter the financial landscape for the construction industry, impacting how projects are financed. 

For developers and businesses looking to secure construction financing, it is essential to stay abreast of these market trends. Understanding the current economic environment, real estate market conditions, and prevailing interest rates can provide valuable insights for securing favorable loan terms.

Glossary of construction loan terminology

• Appraisal: An evaluation to determine a property’s market value.
• Collateral: Assets pledged as security for loan repayment.
• Construction loan: A loan typically secured by real estate to fund a construction project, with funds disbursed periodically as costs arise.
• Construction-period interest: Interest accruing on a construction loan’s balance during the build, typically added to the principal and repaid after the completion of construction.
• Deed of trust: A legal document that secures a loan by transferring the title of a property to a trustee until the borrower repays the loan.
• Fixed rate: An interest rate that remains constant over the loan term.
• Interest: The cost of borrowing money, expressed as a percentage of the loan.
• LIBOR (London Interbank Offered Rate): A benchmark rate that banks charge each other for short-term loans.
• Loan-to-value (LTV) ratio: A term used by lenders to express the ratio of a loan to the value of an asset purchased. It determines the amount of a loan based on the appraised value of the property.
• Mortgage-backed security: An investment secured by mortgages.
• Prime rate: The interest rates banks charge their most creditworthy customers.
• Principal amount: The initial size of the loan, not including interest.
• Promissory note: A written promise to pay a specified sum of money.
• REIT (real estate investment trust): A company that owns, operates, or finances income-producing real estate.
• Underwriting: The process of evaluating and approving a loan application.

As we conclude our detailed guide to construction loans, it’s clear that knowledge is key to understanding the intricacies of construction financing. Grasping the various elements, from interest rates and down payments to the variety of loan types, is essential if you want to steer your construction project toward a successful completion.

 For additional depth, the AGC’s “Guide to Construction Financing” provides thorough insights into the financing process, addressing both the potential advantages and challenges for contractors, complete with an extensive glossary.

 Our website also hosts a wealth of blogs on job costing and financial management, among other relevant topics, serving as a valuable resource for construction industry professionals at any stage of their career.

 TCLI is ready to assist with any queries regarding heavy construction estimating, including feedback, pricing, and deployment strategies. Feel free to contact us for discussion or any questions you may have.