Like any type of commercial or business venture, some type of financing or outside funding is usually required for a business or commercial construction project. Construction loans are an umbrella term that encompasses many types of financing options, depending on the type of project. These can range from an existing business owner expanding the office or retail space occupied by his or her business, to an investor or developer building a “spec” property for immediate sale after completion or a developer who will retain the property after completion for either commercial or residential rental property. There are even instances when there is no actual building involved, only the preparation of raw land for sale or future construction.
The type of project will dictate many factors about the loan itself—from how it is obtained, how it can be used, how proceeds or funds are obtained, how payments are made, and when the balance will be due.
What did you buy and what’re you going to do with it?
The state of the property and the intent of the business owner will dictate what type of financing must be obtained. The most common types of construction loans are:
- Land Development Loan– This type of loan is necessary when a piece of raw or undeveloped land needs to be made construction-ready. The loan can be used to pay for the installation of sewer, water or power lines to the site or simply to fund the work necessary to subdivide the property into parcels to be sold for commercial or residential use.
- Acquisition and Development Loan?- An A&D loan is appropriate if improvements to the infrastructure or existing buildings on developed land need to be made or if raw land is ready to be developed. Both the purchase and cost of improvements to the land before the development can be completed can be funded through an A&D loan.
- Mini Perm Loan – Normally obtained through a commercial bank, this temporary loan is utilized by property owners looking to settle an outstanding construction or commercial property loan on a project that, once completed, would produce income. This is a temporary solution. A long-term financing solution is required to replace a mini-perm loan after the property has generated income for three to five years.
- Takeout Loan ?- Nope this isn’t to pay for lunch for the construction crew. A takeout loan is the permanent financing that the property or business owner would seek to “takeout” or replace a temporary or short-term construction loan. In most circumstances, borrowers will be required by their lender to secure a takeout loan before a short-term loan will be granted.
- Interim Construction Loan?- Usually valid for only 18 to 36 months, an interim construction loan is leveraged to pay for the labor and materials used to construct a project. Once a long-term mortgage is in place, the developer can settle the interim construction loan.
Who’s got the money?
As with most financing, a commercial bank is the first choice for a commercial construction loan as they offer the lowest rates. With these lower rates come more stringent underwriting guidelines and stricter loan-to-value ratios, making them difficult for most developers to obtain. This is still true even as the U.S. real estate market bounces back, leaving many developers looking for alternative sources of financing. Some lender categories to be considered are:
- Portfolio lenders: These lenders finance a commercial loan with the aim of retaining the property as part of the company’s portfolio. These lenders generally are commercial banks, life insurance companies and to some extent pension funds, REITS, and investor funds.
- CMBS Conduit lenders: Commercial mortgage backed securities (CMBS) enable investors to take part in a commercial mortgage within a certain reference frame. Commercial loans that the conduit finances are part of portfolio of assets that are then sold to the investors.
- Sub-prime lenders: These lenders provide finance to lenders whose credit scores do not permit them to avail loans through conventional means.
- Private investors and funds: This category of lenders is more flexible than other lenders and obtains the ‘hard money’ from private individuals or groups. They are willing to finance high-risk projects in favor of high returns.
How to get it?
Lenders have historically applied very strict scrutiny to all commercial lending requests. Commercial construction financing is no exception. In fact,a commercial construction loan proposal needs to very clearly illustrate the objectives, goals and business plan of the construction project to stand any chance of getting approved. A successful proposal must include the following:
1. An executive summary is essential to giving a clear and focused summary of the proposal – this is the loan officer’s first impression of the developer’s plan. The executive summary provides a summary of the project, the necessity or justification for it, an overview of the location and the strengths of the project that will make it profitable.
2. A resume and financial statements for the principals involved in the project, and the contractor who has been awarded the contract for the construction of the project is the second essential component. A list of all successfully completed projects and work experience relative to the project must be included in the resume and will be a key consideration in the approval of loan.
3. Finally, while the details on the projects and the individuals involved are key, the critical factor that any financial institution will look for are the financial or pro-forma projections for the project.Expected income and profits, a complete breakdown and costs analysis and timeframe must be provided. Justification for the projection should include data on property demographic, absorption studies and marketing. Pre-sale information and paperwork on a commercial complex, apartment building, or an office space will help to get the loan approved also as it proves the legitimacy of the financial projections.
Just like any business endeavor, the more homework and preparation put into a commercial construction loan proposal will payoff in the end and make the process go much more smoothly.