Considerations When Seeking Construction Loans

​One major hurdle in any real estate development project is financing, which must cover construction and related costs. When renovating or building residential or commercial properties, financing can be accomplished through a specialized construction loan. Such loans differ from traditional mortgages, which deliver a lump sum toward the acquisition of an existing property. Instead, lenders disburse the capital incrementally as project milestones are achieved.

Lender-deployed quantity surveyors undertake the work of verifying expenses and making sure of appropriate fund outlay as financed projects progress toward goals. This mitigates the often substantial risks involved in any development project and ensures that the budget, which is liable to increase beyond the expected, stays on track.

The construction loan is more challenging to obtain than a traditional mortgage and will often carry a higher interest rate. Despite these hurdles, lenders do their best to ease the strain for borrowers who meet goals as projects progress. For example, they may allow for interest-only payments throughout the construction phase when the property is not yet generating income. Alternatively, they may make locked-in interest rates available when actual construction commences.

Those considering pursuing construction financing should determine loan-to-value (LTV). This starts with defining the “as-is” value of a property that one owns or is planning to purchase. This is compared with the “as-complete” value, or the price that the planned property would attain on the market today. One also defines the construction budget. For example, a piece of property’s as-is value could be $2 million, the as-complete value $4 million, and the construction budget is $1.5 million.

The ideal scenario, given these factors, is that one owns the $2 million property either purchased for cash outright or the mortgage completely paid off. This is known as “free and clear,” with the traditional mortgage lender willing to provide 65 to 80 percent of the as-complete value as a loan. Let’s say the limit is 75 percent. As 75 percent of $4 million is $3 million, this more than covers the $1.5 million required, and the project can move forward (naturally, this is subject to appraisers agreeing with the $4 million as-complete valuation).

More commonly, the borrower does not own the property free and clear but has new or existing financing to navigate on the purchased or owned property. If the existing mortgage against the property stands at $1.5 million, a construction loan is still feasible, as $4 million minus the $1.5 million existing mortgage is $2.5 million. Seventy-five percent of the latter number is $1.88 million, above the $1.5 million loan needed. However, if the existing mortgage stands at $1.8 million, traditional financing can no longer go forward, as the loan amount would exceed the 75 percent as-complete value.

Conventional lenders have other considerations, including the loan-to-cost (LTC) ratio, which reflects the total loan amount divided by the total project cost. The latter spans from when the property is acquired to when the project is completed. Calculating this rate safeguards against uncertainties in preconstruction appraisals. Lenders also look closely at debt-service-coverage ratios, which compare the completed project’s net operating income with proposed loan payments.

For those who don’t qualify, options exist beyond conventional construction financing. These include structures such as joint ventures and hard money loans funded by private investors. The drawback is that these tend to carry higher interest rates or pay out a large percentage of profits to equity holders.

Omar Elrahimy

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