Everything You Need to Know about Construction Loans
Learn about construction loans and basic steps to attain financing for a commercial project.
Commercial real estate development can be an exciting and profitable investment, but oftentimes financing the initial costs can be difficult and stressful. If you’re not sure where to begin, that’s okay. Let’s review the basics of construction loans so you can be more confident when you seek financing for your next project.
Construction Loan Basics
The loan process begins when a developer submits a loan request with a bank or private lender.
Construction loans are typically a short-term loan. The loan will serve to fund both the construction costs of your building and the interest on the loan during the construction period and initial lease-up. When the project is completed and leases up to the market level of occupancy, long-term, or permanent financing, is available to pay off the short-term construction loan. When the lender commits to both short- and long-term structures it’s called a “mini-perm” or “construction-permanent” mortgage. In this case, the lender has agreed to fund the project from breaking ground to ribbon cutting, and even market stabilization.
Always Go Local
From a lender’s point of view, new construction loans are risky simply because there isn’t a operating history to boost the applicant’s credibility. As a result, commercial construction loans are almost always entertained by regional or local lenders deeply familiar with the local markets. Research local credit unions and private lenders with experience in the area to get a feel of who is really involved in the market before making your choice.
Prepare for the Loan Request
What should you include? What should you omit? How should you layout the documents?
Let’s get into it:
General Information and Executive Summary
All the general info is usually include on the cover page of a request and often includes the following:
- Property information (image, full address)
- Timing information (closing date, etc.)
- Borrowing information (complete contact info)
- Company information (including principles, and their contact information, involved in the transaction)
The executive summary is a brief explanation of the financial request. It should ouline the transaction and include property and loan specifics. The executive summary should be direct and concise while also selling the deal to the lender in the process. A solid executive summary should include:
- How you found the opportunity
- Purpose of the loan (e.g., construction, purchase, refinance, bridge, development.)
- Your exit strategy—in other words outlining the timi ng to repay the loan
- Loan terms you are requesting (e.g., closing timeframe, amount, term of loan, interest rate)
Property and Conditions
When it comes to providing information about a potential property or development site, it’s a good idea to include as much detail as possible, including:
- Property name and physical address
- Type (e.g., single-family, mixed use, retail, apartment, office)
- Year built. Include the dates of any remodeling or renovations.
- Number of units (include a breakdown of units/size, if applicable)
- Site details (e.g., purchase price, zoning, utilities, roads/shared driveways, excess land)
- Construction details (e.g., public utilities, parking, deferred maintenance)
- Proposed scope
You should also look into local market conditions. Although any reputable lender will likely conduct their own research (or already have extensive experience around your proposed location) it can be helpful to do your own research to prove you have done your due diligence. Always try and include comparable properties in the area, both active and sold. Other market and location details you could throw in, include:
- Demographic information (check US Census Bureau)
- Maps displaying property and comparables
- Market timing (how long it’s been on the market)
After your application is submitted the loan goes through lender’s underwriting process. Underwriting is an internal vetting procedure used to evaluate risk, the budget, local market conditions, financial capacity of the borrower, and review any other risks inherent to the loan request. Valuations are most often based purely on the projected cash flow of the property, or the real estate pro forma. If the loan is approved, the lender will draft a binding commitment letter. Similar to the terms sheet, but with much more detail, the commitment letter reviewed, negotiated, and accepted—and once signed acts as a legally-binding contract.
Let us know if you have any questions about construction financing.