eSUB Guide: How do Construction Loans Work?

Before the ground breaks on a construction project, one of the very first things to accomplish is securing financing. New property development costs can range from hundreds of thousands of dollars to hundreds of millions of dollars. Property developers and building owners secure construction loans to undertake these projects. The construction loan process can be long and complex due to costs and risk. Navigating the process of securing a construction loan does not have to be confusing. This guide will provide an overview of how construction loans work.

 

Types of Construction Loans

How do construction loans work

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 Land Acquisition and Development Loan

Project owners use an acquisition and development loan to purchase the land and update the infrastructure. The owner must take into consideration the development of streets and installation of water, sewage, and electrical utilities. In some cases, the owner is purchasing developed land. An environmental impact report may dictate that the owner must improve the infrastructure to accommodate the new development. For example, a new multi-family housing unit will add 500 vehicles onto the roadway. To alleviate the congestion, the developer may be responsible for improving the infrastructure to minimize impact.

 

Interim Construction Loan

Because this loan covers the cost of the material and labor during the construction phase,  many refer to this loan as a self-build loan. The duration of the interim loan lasts the estimated length of the construction phase, which is usually 18-36 months. Once the project has reached completion, the project owner can pay off this loan or refinance the loan into a long-term mortgage.

 

Mini Perm Loan

Before the development can start producing income, mini-perm loans provide short-term financing to cover construction costs. They serve as a bridge between the construction loan and mortgage. Developers want to produce revenue and profits through tenancy before applying for long-term financing. This strategy allows them to demonstrate a more established record of success to achieve more favorable loan terms.

 

Take-Out Loan

Developers often replace their short-term high-interest loans with a take-out loan. Similar to a mortgage, a take-out loan provides fixed, amortized payments. The take-out loan serves as the permanent financing portion of the construction loan.

 

Navigating the Construction Loan Process

Very different than a traditional mortgage, developers are asking banks to lend them money for a building that does not exist. There is a large amount of risk that the project will not be completed, so developers and banks must complete their due diligence.

 

Organization

Lenders are going to closely examine everything about you, your builder, and your project plan, so it is important to get organized. They will want to see a thorough business plan for the property development and the strategy for producing revenue. The construction costs and schedule will be thoroughly analyzed. The builder will need to provide their financial documents as well to ensure that they can deliver your project on schedule and within budget. Of course, the lender will look over the owners own business and personal finances with a fine-tooth comb.

 

Request to the bank

When selecting a lender for a construction loan, it is advisable to solicit the local credit unions or regional banks for your project. Because local credit unions and regional banks understand the local market and have relationships with other local property developers and builders for their due diligence, they are an ideal partner for a construction loan.

 

Prequalification: This is the first step of the construction loan process. Using preliminary financial information, the lender will make an initial go or no-go decision. When the lender makes the initial go decision, it issues a letter of intent stipulating all the loan requirements, terms, and conditions. If the owner accepts these terms, the loan application process moves towards the underwriting phase.

 

Due diligence: This phase is the thorough review of all documentation related to the project: budget, project plans, local market analysis, financial backing and success rate of all parties involved, etc. This is the lengthiest part of the process as the lender will need to address any risk. The lender conducts all of the due diligence based on such items as projections for gross income, vacancy allowance, operating expenses, etc.

 

Closing: Finally, once the project owner meets all the necessary requirements, the lender approves the construction loan.

Draw Schedule / Loan Disbursement

The lender and owner work together on the draw schedule for disbursements based on completed work. The lender works closely with the project team regarding updates on the progress of the project.

 

Undergoing a new construction build is a risky endeavor for all parties involved. Similar to the actual construction process, the loan process is long, complex, and based on a lot of paperwork. Getting organized in the beginning helps set the foundation for a successful project.

 

Sources:

The Balance

Commercial Loan Broker Institute

Subcontractor Software Demo

Posted in Best Practices, Construction Software.