What is a construction loan in commercial real estate?
Simply put, a construction loan is used to finance the construction of a new structure or to make major renovations to an existing structure. However, it is important to note that commercial construction loans work very differently from traditional mortgages. With that in mind, this article will explain what a construction loan is, how it works, and the different types of commercial construction loans available. Read on to find out more.
What is a construction loan?
As the name suggests, a ready to build is a specific type of loan used to finance a construction project for a new house or building. Typically, these funds are used to purchase and develop new land, to cover material and labor costs associated with building a new structure, or to perform a large-scale renovation on an existing property. .
Often times, the construction cost for building a new structure from scratch can be high. In fact, when you plan to build a commercial structure like an office or an apartment building, these costs can run into the hundreds of thousands or even millions of dollars. Since few businesses have this type of cash flow, construction loans are used to provide businesses with the funds they need to build these structures from scratch.
How do commercial construction loans work?
It’s important to note that construction finance works a little differently than a traditional mortgage you might take out to purchase your primary residence. With that in mind, we’ve outlined some of the key differences below so that you have a good idea of what to expect when you’re ready to talk to a lender about getting your own financing.
Award and payment structure
The biggest difference between a construction loan and a traditional mortgage is in the way the allocation and payment are structured. With a home loan, the entire loan is repaid in a single payment at closing. Then the borrower is responsible for making a monthly payment of both principal and interest until the loan is fully repaid over many years.
In contrast, a construction loan is paid according to a drawing schedule. With a drawdown schedule, the loan is paid off gradually as the construction project reaches its planned milestones. For example, the first draw of a project may be for the purpose of purchasing and developing the land. Then, after an inspection, the lender could release another draw for the purpose of purchasing initial materials and hiring labor.
In particular, the borrower does not have to make payments on the principal amount until the loan has been fully repaid. Instead, they only pay interest on the amount they have received to date during the draw period. Full principal payment is usually due when construction is complete, at which time the borrower typically takes out more permanent financing to replace the construction loan.
The interest rate you will receive on a commercial construction loan will generally be higher than what you might find with a traditional home loan. Although they vary based on factors such as current rate trends and the borrower’s financial history, it is common to see rates drop from 4% to 12%. Typically, bank loans offer the lowest rates, while alternative sources like hard money lenders often charge a premium to access their financing.
Plus, construction loans come with a few fees that you probably won’t see with a standard mortgage. These fees are usually added to the rest of your closing costs and are as follows:
- Documentation costs.
- Project review fee.
- Fund control fees.
- Guarantee fees.
While the down payment on a standard mortgage can often be as low as 3%, the expectation with a commercial construction loan is that you will have a little more money to put on the table. Expect there to be a deposit requirement ranging from 10% to 30%.
What types of commercial construction loans are there?
Now that you know a little more about the loan terms you’ll encounter when you’re ready to apply for a commercial construction loan, it’s time to take a look at the different construction loan options that are out there. the market. We’ve summarized each type of commercial construction loan to make it easier for you to know which type you need. Read on to find out more.
- Land development loan: Land development loans are intended for the purchase and development of land. However, they can also be used to install items such as water, sewer, and power lines on the construction site.
- Acquisition and development loan (A&D): An acquisition and development loan is generally used on land that has not yet been developed. As its name suggests, this loan makes it possible to withdraw the cash necessary both for the purchase of the land and for its development. Sometimes this loan is also used to cover improvements to the infrastructure of existing buildings.
- Mini-perm loan: A mini-perm loan, also known as an interim loan, is typically used to cover the costs of labor and materials during the construction period. It typically lasts between 18 and 36 months and is fully paid off once a permanent mortgage can be obtained.
- Takeaway : A take-out loan is another name for the permanent mortgage loan put in place after all short-term funding has been exhausted. For projects deemed particularly risky, the lender may require the borrower to secure a take-out loan before granting his request for a permanent mini-loan.
Apply for a commercial construction loan
Finally, like a standard mortgage, this lending process requires a lot of paperwork. While each construction loan lender has their own requirements, here is an overview of the documentation required for loan approval:
- Professional and personal financial documents: Your loan officer will likely ask you for a multitude of business and personal financial documents, including income tax returns, an income statement, and a business plan. Plus, they’ll likely ask for your permission to withdraw your credit score.
- Construction plans: The more detailed construction documents you can provide to your lender, the better your chances of getting approved for a loan. At a minimum, they will need to see construction plans and contractors’ bids.
- Proforma: In commercial real estate, a pro forma is a document containing financial projections for the company once construction of the building is completed, including the expected return from developers.
- Evaluation: Lenders often require an appraisal before approving the loan so that they can ensure that it will be worth at least the value borrowed once it is built.
The bottom line
Although they are two types of financing, construction loans work very differently from traditional mortgages. With that in mind, use it as a guide for commercial construction loans. Armed with this knowledge, you should feel ready to talk to a loan officer about your loan options.