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How Do Commercial Construction Loans Work?


UPDATED: January 31, 2018
How do Commercial Construction Loans Work?

By Terry Painter, Mortgage Banker

Member of the Forbes Real Estate Council

A commercial construction loan has 7 key components. First, the experience of the development team. Second, the financial strength of the key principals. Third, the market demand for the new property. Forth, a review of the building plans. Fifth, a detailed construction budget. Sixth, an income and expense pro forma. Seventh, an appraised value and environmental report supporting the project.
7 Key Components for a Commercial Construction Loan:
1. Experienced Development Team -  The developer, general contractor, architect and property manager need to have experience with a similar type and size project. If the developer does not have the experience they may need to find someone with the experience to co-develop the project. 
2. Financial Strength of Key Principals – The key principals should have a combined net worth larger than the loan request, have the down payment in the value of the land or cash, plus have 10% to 15% in post-closing cash. Good credit is required with the exception of hard money construction loans.
3. Market Demand for the Property - On larger projects a market study may be required. On smaller projected an analysis done by a realtor or by the borrower may suffice. A local lender will know the market and likely know the demand.
4. Review of the Building Plans and Specifications - Having the project ready to pull permits is a plus. At a minimum the lender needs to know that the city or county has given a green light to the plans and specifications.
5. Detailed Construction Budget – this should be done by the General Contractor. This should not be an estimate based solely on price per square foot. But should be a detailed line by line estimate showing the value of the land plus all hard and soft costs.
6. Income and Expense Pro Forma – this needs to support the net operating income required for the permanent loan. Pro forma rents will need to be verified and supported by current market rents. Operating Expenses will need to be supported by operating expenses of similar properties in the sub-market. 
7. Commercial Appraisal and Environmental Report – Prior to loan approval a commercial appraisal will need to be completed supporting the as completed and as stabilized value of the property. Also an environmental report showing no adverse environmental conditions.
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/President   Apartment Loan Store and Business Loan Store
Item Date: 
Monday, April 21, 2014