What are the Requirements for a Construction Loan?
April 13, 2019
Clients often ask, “What are the requirements for a construction loan?” We address the question in this article. Also, we provide useful information about the different types of commercial construction loans. In addition, we contrast and compare commercial construction loans with residential construction loans. Finally, we discuss the best way to obtain a commercial construction loan.
Video: Tips for Documenting Commercial Construction Loans
Types of Commercial Construction Loans
There are many reasons to seek out a commercial construction loan:
- You own or are buying underdeveloped land and want to construct a property upon it.
- You own an old, antiquated property that you want to demolish and replace with a new one.
- In your portfolio is another property you own and want to rehabilitate, renovate and/or expand.
- You own a property and want to repurpose it.
Just as there are different reasons for a commercial construction loan, there are different types of commercial construction loans. Therefore, we will now describe the most popular types of commercial construction loans.
Land Development Loan
You apply for a land development loan when you already own raw, undeveloped land and want to develop it. For example, you might purchase a large plot of land and subdivide it into parcels for residential or commercial use. This might require expenditures for clearing, surveying, fencing, deed registration, toxic waste removal, road building, landscaping, drilling and more. Also, you might want to improve the land by developing infrastructure. This would include installing water, sewer, power lines, telephone, cable, etc.
Acquisition and Development Loan
An A&D loan can pay for the purchase of land and any improvements to make the land ready for development. You might need an A&D loan if the raw land is ready for development or improvement. Specifically, this might involve improving the infrastructure and any existing buildings on the land.
Interim Construction Loan (Bridge Loan)
This is often an interest-only loan with a balloon payment due within a year or two. You use it to pay for construction activity, including materials, supplies and labor. The lender may structure the loan to release it in installments as work completes. You refinance the loan when you complete construction and obtain a certificate of occupancy.
This is another temporary loan that refinances a short-term construction loan. You use the proceeds from this loan to settle the interim construction loan and stabilize the property’s rent roll. A typical term for a mini-perm loan is two to three years, though shorter and longer terms are available. Sometimes, these loans are interest-only. Normally, you keep the mini-perm loan in place until the property stabilizes. Typically, stabilization means that you have achieved 90% to 95% occupancy for a minimum period of 3 to 6 months. This sets up the basis for representing an accurate net operating income figure in preparation for a takeout loan.
A take-out loan “takes out” temporary financing and replaces it with a long-term loan, such as a permanent mortgage. Often, developers prearrange take-out loans so that they can plan their financial obligations when refinancing. Commercial take-out loans often have amortization periods of 20, 25 and 30 years.
A sponsor or sponsoring syndicate elicits relatively small loans and equity contributions from investors. Usually, investors are accredited. This is a relatively new way of raising construction financing, and its long-term viability remains to be seen.
What Are the Requirements for a Construction Loan?
There are several requirements that a construction project must meet to qualify for a construction loan.
Lenders, with good reason, prefer to work with borrowers who have excellent credit scores. A construction project is inherently risky, so it’s not surprising that lenders want to control risk. While there is no hard-and-fast rule, borrowers should have a minimum credit score of 680. Though most institutional funding sources require a minimum credit score of 720 or better. Commercial lenders look at the credit scores of the business owners as well as that of the businesses themselves.
Prospective lenders improve their prospects if they have a good industry background. That means a successful record developing properties and repaying debt on time. If you do not have industry background, you should consider partnering with someone who does.
There are several ratios that lenders evaluate when underwriting a construction loan. These include:
- Debt-to-Income Ratio: Generally, lenders prefer a DTI ratio no greater than 43%. The formula for the ratio is total monthly debt payments / gross monthly income. As you reduce your debt, your DTI ratio decreases, thus improving your prospects with lenders.
- Debt Service Credit Ratio: This is equal to net operating income / current annual debt obligations. Of course, lenders prefer a higher ratio, as this indicates that you can pay your bills. Many lenders require a minimum DSCR of 1.25, though, this is property type and deal dependent.
- Loan-to-Cost Ratio: You calculate LTC ratio as the construction loan amount / estimated project cost. Most providers of commercial construction loans limit the range between 65% and 80% LTC. As a borrower, you can substantially increase your chances of commercial construction loan approval by increasing your equity contribution.
- Profit Ratio: This is profit divided by cost. Lenders prefer a profit ratio of at least 20%.
A sponsor (a borrower) can improve their funding chances by preparing for success. First, find a reputable, licensed general contractor and a professional construction building team. Also, you’ll need a complete set of architectural and building plans, and an detailed, construction budget. The Budget should be prepared by a knowledgeable, skilled professional with many years of development experience. Further, you’ll need building permits and possibly zoning variances. Finally, be ready to place a sizable down payment and to provide suitable collateral.
Commercial Construction Loans vs Residential Construction Loans
Obviously, construction loans pay for building, developing or renovating property. While commercial construction loans share many characteristics with residential construction loans, they differ in several ways:
- Generally, residential construction loans have no prepayment penalties, lower interest rates, longer amortization periods and longer rate locks.
- Closing costs are lower for residential loans, including fewer or no points.
- Commercial construction loans can be more flexible. Residential loans often receive government guarantees, and therefore must conform with government requirements. Furthermore, banks typically sell mortgages to securitizers who require standard terms. Commercial construction loans result from negotiations between borrowers and lenders and can include many custom features.
- Residential loans are typically no longer recourse loans. Commercial loans can be recourse or non-recourse.
- Most commercial construction loans are much larger than residential loans, unless of course you’re building a mansion for yourself.
How to Obtain Commercial Construction Loan Financing
Now that we’ve answered, “What are the requirements for a construction loan?”, where should you obtain your loan? Your best source of construction financing is through a loan broker like Assets America®. The reason is that we have a large network of both institutional and private money funding sources. Our network partners compete with each other for your business. Therefore, we can find you the best loan available in the shortest possible time. We vet our lending sources, and do our absolute utmost to find the best funding solution. We have an incredibly high closure rate. Our commercial construction loans start at $5 million, with no upper limit. Contact us today for more information at 206-622-3000!