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How Do Commercial Construction Loans Work?

UPDATED: April 26, 2021

 

By Terry Painter/Mortgage Banker, Member of The Forbes Real Estate Council

Author of: “The Encyclopedia of Commercial Real Estate Advice” Publisher – Wiley

 

A commercial construction loan works by qualifying the borrower and the property for these 7 key components:

  1. An Experienced Development Team
  2. Financial Strength of the Key Principals
  3. Market Demand for the Property
  4. City or County Green lighting the Project
  5. Construction Budget that Supports the Loan
  6. Pro forma that Supports the Project
  7. An Appraisal and Environmental Report that Supports the Project

 

Commercial Construction Loan Rates Today

Rates as of: 06/13/2021

FHA Commercial Construction Loan (Multifamily)

on the 10 year US Treasury Rate. Rate is fixed for the life of the construction loan and also for the full 40 years for the permanent loan.

3.49% - 3.89%

National Bank Commercial Construction Loan

Based on the 30 day libor rate. Rate changes monthly

3.79%

Life Company Commercial Construction Loan

Based on the 30 day libor rate.  Rate changes monthly

4.25%

Regional Bank Commercial Construction Loan

Based on the 30 day libor rate.  Rate changes monthly

4.45%

Community Bank Commercial Construction Loan

Based on Prime Rate.Rate changes has prime rate changes

4.75%

Private Debt Fund Construction Loan

6.50% - 8.25%

Hard Money Commercial Construction Loan

7.95% - 12.00%

 

7 Key Components Needed for a Commercial Construction Loan to Work

 

1. An Experienced Development Team – When I first started lending on commercial construction projects over 20 years ago, it was so much easier to get a commercial construction loan. These loans were made primarily to the quality of the project and the development team – we are talking about the developer, architect, general contractor and property manager’s experience. This gave the lender a cozy feeling that the construction would be completed on time and at budget. Today the lender will check the credentials and experience of these professionals to make sure they are more than qualified for size, and quality of the project.

 

2. Financial Strength of Key Principals – Since 2008, with the after affects of the great recession, the financial strength of the key principals (those responsible for the loan) became most important. Today a commercial construction lender wants to know that the developer and/or key principals on the loan have deep pockets. For a bank, this will be a net worth 1.5 to 2 times the loan amount and 20% of the loan amount in post-closing liquidity. This is because the greatest risk to a construction lender is the uncertainty of how long the project will take to build, get its certificate of occupancy and get stabilized at market occupancy. The last thing a commercial construction lender wants to do is take back a half completed project which can be tied up in litigation and red tape for years. This is where the extra cash of the key principals comes in. Community banks will want the key principals that have the most financial strength to have skin in the game, by providing most of the down payment. Debt fund private lenders are not as finicky about this.

 

 

3. Market Demand – A commercial construction loan requires that there is proof of market demand for the project – that it is supported by market occupancy, rents and expenses. On larger projects a market study may be ordered. On smaller projects the developer and lender will research market demand.

 

In 2015 we were evaluating a 65-unit luxury apartment complex development near downtown Portland, Oregon for financing. Rents were skyrocketing because of the lack of multifamily housing. In fact, there were peaceful demonstrators demanding that rents come down. The demand for the project seemed to be a no-brainer. But after checking with the city, we found that there were 5 new apartment construction starts coming online. This greatly reduced the market demand and this project was axed. Sure enough in late 2016 there were too many luxury units available for rent in this sub-market and rents took a tumble.

 

4. City or County has Green Lighted the Project – In my book, “The Encyclopedia of Commercial Real Estate Advice,” I go over in depth what it takes to become a developer, to find the land, get the buildings designed and go through the pre-development process with the city. Keep in mind that a construction lender and their team can spend over 50 hours just evaluating the proposed construction and prequalifying you and the project for financing. So if you are just starting pre-development (this can take 6 months or longer) and are a long way from getting all the entitlements approved, the lender will be hesitant to start evaluating the project for financing. This is why it’s the easiest to get a construction lender to jump in full steam if your project is permit ready.

 

This is not to say that you should not talk to a construction lender about your project until you are permit ready. Just that a lender will not want to spend a lot of time analyzing the deal until you are close to breaking ground. It will be essential for you to discuss your future construction project with many lenders to determine which one will be the best fit based on down payment and loan expenses. 

 

5. Construction Budget – This needs to support the size of the loan or you will need to cut the construction costs down. You will not want to spend the money on full plans and specs until you get all your entitlements approved. Prior to that you will need to get an estimate from a general contractor based on your preliminary architectural drawings what it will cost to build. You will need full plans and specs to get construction bids and land a construction contract. All construction lenders have a maximum loan to cost that will constrain what they can lend you on the project. But to pre-approve your construction loan they will need at a minimum, a ball-park estimate of hard and soft construction costs. Be prepared to have the actual construction budget based on a construction contract be 15% to 20% higher. From my 24 years of experience doing commercial construction loans, actual bids seem to always go much higher than construction estimates. 

 

6. Pro forma that  Supports the Project – Your pro forma is really the meat of a construction loan because it will show the lender that once stabilized the project can support the estimated permanent loan payments. This projection of income and expenses needs be for a minimum of 3 years from when the property starts leasing up. It also needs to be based line by line on facts not fiction. You will need to provide current market rents from similar size and quality properties and estimated expenses from a qualified property management company. 

 

7. An Appraisal and Environmental Report – Don’t order these yourself. If you do, your lender will not be able to use them. They need to order their own. The appraisal will need to verify based on the sales comparable and income approaches that the value of the project will support the size loan you are applying for. The appraisal will have three valuations – the current market value of the land, the value of the completed project and the value of the completed stabilized (rented) project. The environmental report will verify there is no contamination on the land. 

 

Nine Commercial Construction Loan Lenders/Programs

 

1. Local Community Banks –  are often the best for smaller projects under $3 Million. This is because they know what they need in their community for the type and size project you have in mind. All banks have a limit as to how much they can lend to one customer, so be sure to ask this. These banks can usually lend up to 75% of cost during good economic times and 65% - 70% during recessions. Loans start at $150,000 and go up to $7,000,000.

 

Better yet, if 51% or more of the proposed construction project will be occupied by your business, most banks can use easier to qualify for SBA financing where 75% of the loan is guaranteed by the United States government. These loans go up to 90% of appraised stabilized value. Interest rates are usually tied to prime rate and adjust monthly.

 

2. Regional Banks – These banks can usually lend up to $25 Million to one customer. They require financially stronger key principals, have lower rates often tied to LIBOR swap rates that can be locked for the duration of the construction loan. They can usually lend up to 75% loan to cost. Loans start at $10 million and above.
 

3. Large National Banks – They have the lowest rates, but require developers and key principals to be very strong financially and have done at least 2 – 3 other like size projects. They lend up to 70% loan to cost. Their rates are usually fixed and are tied to LIBOR swap rates. Loans start at $10 million and above.

 

4. Private SBA Lenders – Again, just for owner occupied properties (Self-Storage and Hotels can qualify), these lenders are often easier to qualify for, as they have less regulation than banks, and sell their loans on the secondary market but retain the loan servicing. SBA 7A loans go up to $5 Million, and SBA 504 loans go up to $12 Million. 

 

5. HUD/FHA – This program is only for apartment/multifamily properties and is the best commercial construction loan program in America. This is because it is non-recourse, lends up to 85% of cost and includes a 40 year fixed fully amortized perm loan. Also, it has the lowest rates tied to the 10 year treasury yield. On the down side, this loan takes 10 months to a year to fund. But this doesn’t have to be a problem if you apply while still in pre-development. I have been doing these loans since 1999 and I can tell you with certainty that you have time to not only get your project approved by the city, but to raise investors too. Loans start at $5 million and above.

 

For more on HUD Multifamily Lending Programs: https://apartmentloanstore.com/loan-product/hud-loans

 

6. Private Debt Fund Lenders –  Some of these lenders are publicly traded. They raise funds from individual and institutional investors. So do equity participation  and earn a preferred return on that portion. These loans are often non-recourse and go up to 75% loan to cost. Rates are in the 7 – 8% range.
 

7. Crowdfunding Lenders – These lenders raise their funds from private investors.  They prefer lending equity as well as debt and earn a preferred return on their equity contribution. Loans go up to 75% of cost with higher rates in the 8% range. Most lend at $10 million and above.

8. Life Companies – They have some of the lowest rates tied to LIBOR swap rates, but require very experienced and financially strong developers and sponsors. They start lending at $20 million and above and go up to 70% loan to cost. 

9. Hard Money Lenders – Of course, these loans are easier to get approved for and should only be used as a last resort. They go up to 75% loan to cost and often up to $10 million. Expect rates to be in the 9.00% - 12.00% range. This only works if you can build quickly. Beware of hard money lenders that box you in with a year to build and then charge you exorbitant fees to extend the loan if you don’t complete and stabilize the project. Worse yet, some of these lenders charge you full interest on the total loan amount starting the day the loan closes. Ouch!  That is a recipe for disaster!

 

For information on Multifamily Construction Loans:

https://apartmentloanstore.com/loan-product/construction-loans

 

Commercial Construction Loan Submission Check List

 

For the Property

▪ Executive loan summary

▪ Description of improvements to be

built

▪ Description of the land with aerial

photos

▪ Proximity to main highways and

shopping

▪ Purchase and sale agreement on land

▪ Detailed construction budget

▪ Approved zoning and other entitlements

▪ List of hard and soft costs paid to date

▪ Feasibility study

▪ Site plan, floor plan, and elevation

drawings.

▪ Operating pro forma for the first three

years

▪ Resume of the general contractor and

projects completed

▪ Copy of leases or intent to lease

▪ Management company resume

 

For the Borrowers

▪ Current three-bureau credit report on

all key principals

▪ Current personal financial statement

for all key principals

▪ Schedule of real estate owned

▪ Last three years of 1040 tax returns

▪ Resume or bio of key principals

 

How Much do you Need to Put Down on a Commercial Construction Loan?

First of all you need to determine as accurately as possible the total project costs. This includes the value of the land, plus hard and soft construction costs. Keep in mind that the value of the land less what you owe on it will be part of your down payment. Here is a general rule of thumb on this:

 

Community Banks – Expect to put 25% down during good economic times. 30% - 35% down during a recession. 

 

Credit Unions – They are new to commercial construction loans but generally will expect you to put 25% – 30% down.

 

 SBA – Can only be used if your business occupies 51%, but if the property is self-storage or hospitality than you don’t have to worry about this. The guidelines for these loans state as little as 10% down, but realistically 15% – 20% down is were the SBA 7a and 504 lenders are comfortable at.

 

HUD/FHA For Multifamily/Apartment Building properties only. 15% down as long as the projected net operating income of the property supports an 85% loan.

 

Life Company – 30% down minimum.

 

Private Debt Fund Lenders – 25% down during strong economic times, and 30% during recessions.

 

Hard Money Lenders – 25% down is the norm during good and bad economic times.

 

 


 

 

Do you have the Development Experience?
Getting a commercial construction loan is not an easy process. There are so many parts involved. In the writer’s opinion, for those who have done other types of commercial property investments, but have no experience in commercial construction development it would be best to partner with an experienced developer. Why? An analogy would be that your flying experience is limited to a one-propeller plane, but you want to now go on to fly a commercial jet. Yes, that’s correct. A commercial construction loan is that much more complex. 
 
If you have no experience in commercial construction, get a partner who does. You can still own most of the project. You can pay the development consultant a fee or give them a small ownership of the property. Make sure that you have enough knowledge about commercial construction so that you are on the same page as your partner in making decisions in the directions you want to go. If you have very little knowledge about commercial construction investing, your partner may make a decision you do not understand, and you do not want  regrets later.
 
1. The Commercial Construction Loan Process
The first step of the commercial construction loan process the developer turning in a request for a loan to the lender.  Preparing a modified business plan summarizing the projects scope, demand, financial strengths, construction budget, as well as the experience and financial strength of the developer and key principals.  The experience of the general contractor and property manager is also needed. Design drawings and a computer rendering of the completed project is recommended.
 
You have the choice of lenders near the property such as local community banks, or lenders focused nationally such as FHA, Life Insurance companies, and national banks. Private lenders can be an option for those who want non-recourse construction or simply do not qualify for bank financing. For borrowers with poor credit hard money private money may be the only choice. The advantage of a local lender is a greater understanding of the local market as well as knowing the reputation of the local developers of real estate than lenders outside of the community. The advantage of using national lenders is that you will usually get better rates and terms.
 
A lender will have to make sure that both the borrowers and the project qualify for both the construction loan and the permanent loan. Actually commercial construction lenders often start with making sure the projected net income of the property will support the debt service coverage ratio required by the permanent loan.  
 
You need to think about getting two loans:
i. Construction Loan – This loan finances the new construction as well as the phase to lease the property to tenants. When the property is leased up, the property is considered stabilized.
ii. Long term loan (permanent financing) – After the property is stabilized, the commercial construction loan is taken over by a long term loan.
 
Many construction lenders will do a construction loan roll over to perm. An FHA loan program, also known as HUD, combines the two loans into one loan for multifamily properties. Keep in mind that is important that you understand the different types of loan programs in order that you make the right loan decision.
 
2. Underwriting Process  for Commercial Construction Loans
After the developer submits the loan request, the lender usually takes a week or more to make a yes/no decision for pre-approving the loan. If the lender gives it’s okay for the loan, the lender initially will give provide a term sheet containing conditions and terms for the loan. However, there will be the provision that everything submitted to the bank must be reasonable and correct. At this point the term sheet is non-binding. Next, the loan has to be underwritten which makes sure that the developer, key principals and the project itself meet the lenders underwriting guidelines.  And finally, there is loan approval followed by loan closing and funding.
 
What the lender evaluates during underwriting:
i. Details for budget of construction
ii. Proforma for the project
iii. The team responsible for development
iv. Conditions of the market locally
v. Guarantors financial strength
vi. The loan’s other risks
vii. The appraised value of the completed project and a clean environmental report
 
The following documents are typical of what is needed for underwriting:
i. Real estate schedule owned 
ii. Personal financial statements 
iii. Tax returns of Guarantors as well as borrowers
iv. Proforma for the project that is proposed
v. Estimates of costs
vi. Liabilities of guarantors that are contingent
vii. Specifications for engineering
viii. Complete project plans
ix. Uses and sources for the construction loan
x. Other documents needed for supporting the requested loan
 
A major difference between investment property lending and construction lending is that when underwriting a construction loan there is no financial operating history. Thus, the property value and project finances have a basis based on the pro forma. This makes the loan substantially riskier. Thus, the underwriter will do due-diligence on the general contractor, the team responsible for development, the key principals, and current conditions of the market to mitigate the risk. The underwriter will rely on the commercial appraisal to support the project as well. 
 
At the time loan approval is granted, the borrowers are given a binding commitment letter. Having similarities to the term sheet, the commitment letter has many more details concerning loan terms. And importantly, unlike the term sheet, the commitment letter is binding legally providing all conditions in the commitment are made. 
 
3. Closing of Commercial Construction Loan and Afterwards
Loan closing is the next step after the credit manager or loan committee grants loan approval. Loan closing for a commercial construction loan is very complex with a huge amount of procedures and documents involved. Most often the developer is given a commitment letter and a closing checklist prior to ordering loan documents.  The checklist gives the details of what needs to be completed prior to loan closing and funding.  Usually the borrowers and lenders attorney’s will need to negotiate the closing documents after they are issued.
 
Again, before getting involved in commercial construction loan investment, it is essential to understand how commercial construction projects work along with understanding the loan process. Having a good understanding of the processes involved will help demystify it, soften the complexities, and help secure greater success in the outcome you want.
 

Commercial construction loans are a complicated process. But once you understand how they work and start thinking like a commercial construction loan lender, you will know what it takes to obtain one. At Apartment Loan Store, a commercial mortgage banking firm, we work backward and start with prequalifying the permanent loan. We recognize that commercial construction loans have seven key components that will need to be analyzed by the lender to pre-approve the loan. Here they are:

 

1. Start With the Income of the Property – This is because the size of your construction loan will ultimately be constrained by the size of your permanent loan – what the net operating income of the property can cash flow to obtain a permanent loan. Once you know the square footage of the building or the number of units, do a pro forma rent roll and estimate the gross rental income of the property based on currrent market rents. Next estimate expenses, including real estate taxes, insurance, maintenance, management, etc. Next complete a pro forma (projected) annual income and expense statement and come up with the estimated annual net operating income (income minus expenses). Now figure what the debt coverage ratio will be for the permanent loan. Divide the annual net operating income into the annual loan payments and multiply this number by 100: NOI / ADS = ( ) X 100 = DCR. This ratio should be at least 1.25 for multifamily and 1.35 for a multi-tenant property. All commercial loans are restrained by a debt coverage ratio.

 

2. Estimate the Appraised Value – This is because the size of your permanent loan will also be constrained by the appraisal. Get a commercial realtor to look at sales comparables for this type of commercial property and get a realistic estimate of what the property will appraise at when completed and stabilized (leased at market occupancy). Most construction loans are maxed at 75% of the appraised value.

 

3. Estimate the Cost of Construction – Start with the cost of the land. Then Include all major hard costs: the cost of excavation, foundation, framing, drywall, roofing, electrical, plumbing, pavements, HVAC, services, interior work, etc. Then include all soft costs: plans and specs, permits, legal, taxes, insurance, and loan fees. Then add on a 5% contingency (cost-overrun fund). It’s best to get an estimate from your general contractor.

 

4. Estimate the Size of Your Construction Loan – Most construction loans are maxed at 75% of cost. Some do go to 83.3% of cost. Make sure that your maximum construction loan is not larger than what can be supported by the property’s net operating income and the appraised value.

 

5. Determine If You Have the Financial Strength and Credit – You will need good credit (a score of 680 or above). You can always qualify for a hard money loan if your credit is not great (if the project can afford it). You will also need to have a net worth at least the size of the loan you want to obtain and have the down payment, closing costs, plus 15% to 20% in post-closing liquidity. If your personal financial statement doesn’t support this, then perhaps you can bring on a partner with additional financial strength.

 

6. Determine If You Have the Experience – Lenders today want to make commercial construction loans to experienced developers that have a track record of completing and renting out their new development projects. If you don’t have prior experience, you might need to bring on a partner who does.

 

7. Determine If Your Contractor Will Qualify – Lenders will require you to have a licensed bonded contractor with a resume showing they have completed similar construction projects. The lender will want to check the contractor’s credit and references. On larger projects, the contractor might need to be financially strong enough to qualify for a performance bond.

 

At Apartment Loan Store and Business Loan Store we have specialized in commercial construction lending since 1997. We would be pleased to assist you in prequalifying for a commercial construction loan up to 83.3% of cost. We have many loan programs to choose from. Call one of our friendly loan specialists today.

 

By Terry Painter/Mortgage Banker, President Apartment Loan Store and Business Loan Store

Author of:  “The Encyclopedia of Commercial Real Estate Advice” Publisher – Wiley

Member of The Forbes Real Estate Council

 

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