Construction Loans: What Borrowers Need to Know

Competition for construction funding is fierce in today’s environment. Construction loans already are more difficult to obtain because fewer lenders are willing to fund these commercial real estate deals. There is more risk involved due to the speculative nature of construction projects and the time it takes to complete them.

Still, real estate development remains popular and lenders who do fund construction loans are currently overwhelmed with requests. That means the easier deals will quickly make their way to the top of the stack, while others will languish.

Here are some insights that can help borrowers craft a successful construction loan request:

Sell Sponsor Qualifications

Borrower net worth and liquidity will play a key role in qualifying for a construction loan. Net worth of the borrower should be equal to the loan amount requested, and cash liquidity should equal at least 10% of the loan.

To overcome any deficit in that calculation, the borrower can bring in a co-guarantor or partner who can bolster those qualifications. It is best to anticipate this problem and line up this partnership prior to submitting the loan request.

Borrowers with little or no proven construction experience will face an uphill battle getting a loan approved.  This can be overcome, however, by partnering with a general contractor with proven experience building projects similar in scope.  Be prepared to submit the contractor’s bio and a list of completed projects along with construction budget details.

Financial Metrics

Another key factor is the level of financial commitment that the borrower is willing to take on. That is evidenced by how much cash the borrower is putting into the deal, both individually and through equity partners. Here at Boulder Equity Partners, we can fund up to a maximum of 85% of the construction cost.  The loan amount also cannot exceed 65% of the stabilized value of the property once completed, so be sure to do your math ahead of time.

To be conservative, a borrower should presume they need to come to the table with at least 25% of the construction cost, in the event the numbers do not pan out to get the full 85%.  If the borrower does not have the requisite cash, equity investors will need to be in place.  Secure these equity investors before presenting your loan application if you want to make a good first impression.

Borrower Equity Contribution

Purchasing the land and securing entitlements, engineering, architectural drawings, permits, and so on takes time, effort, and money.  Track all these expenses. They can be considered as equity participation on the borrower’s behalf when applying for the construction loan.

What is sometimes more challenging to evaluate is “implied equity” —when the borrower purchases the land at a perceived discount and then claims a much higher equity contribution. In a situation where the property was purchased years ago and has substantial appreciation,  where the borrower has obtained entitlements like building lot approval or rezoning, or where the borrower has added improvements, then the lender may count that toward borrower equity.  However, if the borrower only purchased the property a few short months ago and has not put money into improvements, implied equity is not likely to factor into the property valuation or equity calculation.

As a construction lender, Boulder Equity Partners will be looking at the borrower’s basis — the actual amount of cash the borrower has personally committed to the project.  Borrowers with a low basis can overcome this challenge by bringing strong equity partners to the table.

Permits and Zoning

When preparing for a construction loan, builders are busy applying for proper zoning and permits. While it is common for a construction loan request to be submitted while permits are in process, ultimately, funding will not take place until those permits are issued.

To the extent the project requires a change in zoning, like converting commercial use to multifamily, the borrower may need to wait until that zoning variance is approved before applying for a construction loan, as that process can often take months.

Interest Reserve

An interest reserve is an amount set aside at loan origination to cover the monthly payments. It is common for the construction loan to include an interest reserve, to cover the cost of interest payments while the construction project is in process.

Keep in mind that this will increase the loan amount and hence the cost of the loan to the borrower.  It could also negatively impact the loan-to-cost and the amount of funds available for construction.

If the borrower is able to bring cash to the table to cover interest costs, it could reduce the loan amount and resulting cost of capital.

Focus on Market Comps

If the units are going to be leased, the borrower will want to provide market rental comps in close proximity and square footage to the proposed construction project.  If the units are slated to be sold, provide recent market sale comps.

Our analysts will look closely at market comps using specialized data points. Major discrepancies between the borrower’s numbers and the lender’s metrics will impact the terms of the loan offer and can result in a decline. The borrower needs to show diligent market research and should be prepared to make a business case for their numbers.

Pre-sales and pre-leasing are the strongest methods to determine projected value. While showing letters of interest and inquiries from prospective tenants or buyers is persuasive, the best evidence to present to lenders is signed contracts or leases with paid deposits. That is a clear indication of market interest.

Horizontal and Vertical Construction

Construction projects include two primary components, deemed horizontal and vertical construction.  Horizontal includes efforts such as grading, installing roads, and bringing in utilities.  Vertical is generally everything else, from pouring the foundation to building the structures.

It is typical and perfectly acceptable to include both horizontal and vertical construction components in a loan request.  What is more difficult in today’s environment is a loan request that is only seeking horizontal funding, especially with the hyper-competition for construction funding.

Realistic Timeline

The time frame for completion of the project is tied to the loan terms and payments. Whether the request is for a multi-phase project or a simple rehab, the timeline must stand up to scrutiny and be both realistic and reliable.  A typical construction loan time frame is 12-24 months.

If the units are going to be leased, it may be necessary to refinance the construction loan into a bridge loan while it is in lease-up phase, then convert to a long term, low interest loan once the property is stabilized.  If the units will be sold, the loan may need to be refinanced into a bridge loan until the sales are completed, with provisions for partial release and paydown as the units are sold.  Boulder Equity Partners provides these types of bridge and long-term financing.

Boulder Equity Partners LLC is a nationwide lender for commercial real estate offering a wide range of loan programs including construction loans, perm loans, and bridge loans that can be migrated to perm loans.