Construction Financing: 20 things you should know

Sheridan Bibo

Are you ready to break ground on your next – or maybe your first – development? Below is everything you need to know to start.

  1. A construction loan is a short term loan that is used to finance the building of a real estate project.  
  2. Many banks, credit unions, private and government lenders offer construction loans.
  3. Some may have a specialized construction loan team who generally have more experience than institutions without teams.
  4. Since the 2008 real estate downturn, lenders are more conservative and prefer to stay within their geographical area.
  5. Construction loans usually work on a draw structure; the borrower is reimbursed for their expenses during construction at regular intervals.
  6. There are two types of construction loans:
    1. Construction-only loans: these loans must be paid off once the building is complete. They are a good choice if you are fairly liquid or planning on selling after completion. If you choose to hold the property, you can move into a permanent loan after construction.
    2. Construction-to-permanent loans: The cost of construction is covered and the loan converts to a permanent mortgage at closing. You can often lock your permanent interest rate at closing, which secures you against rate rises and guarantees steady payments.
  7. In order to move into a permanent loan, your property will need to reach stabilization. Specific requirements to qualify for stabilization will depend on the asset and loan type.  
  8. Construction lending is riskier than other types of lending because there are so many potential pitfalls. The ownership, management plan, and general contractor will all need to be approved by the lender.
  9. Your budget should have hard costs (direct construction labor and materials costs), land costs, soft costs (all the costs you don’t see, for example, permits) and a contingency reserve for unexpected costs (this is usually at least 5% of soft costs).
  10. Lenders look to invest in projects that have a clear, profitable future. For single and multi-tenant properties, lenders prefer the project to be pre-leased as this reduces their risk. However, it is possible to finance properties without pre-leasing. For hotels and multifamily properties, a market study that supports the project is important.
  11. Construction loans are based on Loan To Cost (LTC) and Loan To Value (LTV). LTC is the loan amount vs. the cost of the project. LTV is the loan amount vs. the as-completed appraisal value of the property.
  12. Today, most lenders usually don’t finance more than 75% of a project’s value. Depending on the project, the threshold may be lower or higher than 75%.
  13. Preleasing and lower LTC and LTVs represent less risk which can be reflected in a lower interest rate and less need for additional collateral and personal guarantees.
  14. In today’s lending environment, personal guarantees are almost always required. There can be one or several, and they can be capped at a certain amount or for the full loan amount.
  15. The process requires more time, resources and documentation than a traditional mortgage.
  16. The timeline for the loan will depend greatly on the lender you are working with, how far along with your documents you are and how efficient communication is. It is suggested you look into financing at least 3 months before you want to close the deal. More if you are not working with a broker. If you are sourcing agency funding, such as a HUD 221(d)(4), timelines are greater and it is recommended you start looking financing at least 18 months before your plan on breaking ground.
  17. If you start construction before closing the loan, you will be breaking lender priority on the title of the property and you will need to work with the lender, general contractor and title company to ensure the loan and lender are able to work with this. Most projects start after the loan is closed to avoid extra costs and paperwork.
  18. Some lenders will charge a construction loan management fee, separate from the loan fee. Others will charge it within the loan fee or ask you to work directly with their third party.
  19. If your property is 51% owner-occupied and no more than $20 million, you may qualify for an SBA 504 loan. Research more about this loan or ask your mortgage broker if it is the best fit for you.
  20. If you cannot source funding for the total cost of your project, and you do not wish to make up the remainder with equity, you may want to source mezzanine financing. Mezzanine financing comes at a higher interest rate and usually last the term of your initial loan.

 

Development and construction is a long, complicated process and without the funding, it cannot be done. That’s why it’s important to make sure you are doing all you can to get the best financing possible and working with the best team. If you have any questions or are ready to get to work, River Oak Capital is here to help. Call me today on 904-878-2228 or send an email to sbibo@riveroakcapital.com.

 

By Sheridan Bibo – VP of Originations