What Is a Construction Loan?
Construction loans provide short-term financing where the construction cost of a building project may otherwise be too expensive to pay for in a lump sum. Many traditional and private lenders offer construction loans with interest rates between five and 18% on permitted or permit-ready lots. Typical construction loan terms can range anywhere from 12 – 18 months.
Eagle Commercial Funding offers ground-up construction loans between $500,000 and $5 million for non-owner-occupied single-family properties, townhomes, multi-family, and mixed-use properties. Rates start at 8.49% and, depending on the appraisal process, can close within 10 – 20 days – more than two times quicker than many traditional lenders.
Unlike a traditional mortgage loan, a commercial building loan is paid in several different stages. During the construction process, you only pay interest on the amount you’ve received, rather than paying interest on the full amount of the loan. Payments on the principal don’t begin until the construction is complete.
For example, if you received $100,000 from your lender for the first phase of the project, you’ll only pay interest on that $100,000. Once you’ve received the funds for and begun the second stage of the project, you’ll pay interest on the $100,000 from the first stage, as well as the interest on funds received for the second phase.
These steps or milestones are established before the project begins and the funding is released. Once you’ve reached a milestone in the project plan and an inspector has reviewed the work, your lender will then make the next loan installment.
To further understand the commercial real estate construction loan process, review the steps below:
- Contact a lender: In business and life, time is money. Finding the right lender who can provide a swift closing period and competitive rates is key to profiting from your construction project.
- Commercial construction loan underwriting: Underwriters for commercial real estate construction loans look at common financial ratios to determine if lending the money for this project will be profitable for all involved. They typically evaluate the loan-to-cost ratio (LTC), loan-to-value ratio (LTV), debt service coverage ratio, profit ratio, and net-worth-to-loan-size ratio.
- Lender commitment letter and approval: Upon approval, the lender will issue a formal letter of commitment. This legally binding document specifies the total loan amount, the purpose of the funds, repayment expectations, and all other requirements.
- Borrower is put on a draw schedule: The draw schedule is similar to a project plan. Major steps in the construction process are outlined with an estimate of their costs. Once the first step is complete, the lender will release the funds for the second step, and so on.
- Inspection during construction: Once a step in the draw schedule is complete, an inspector will ensure everything is in working order and nothing is missing. Depending on how soon an inspector is available, this can add time to the project – especially in strong real estate markets.
- Paying off the loan: Your initial construction loan may be refinanced to a long term mortgage loan once construction is complete. At this point, you’ll begin paying both the principal amount and the interest.
Requirements for a Construction Loan
Before applying for commercial real estate construction loans, ensure you’ll qualify for an amount that will cover the costs of your project. As previously mentioned, time is money, and applying for commercial loans takes time. Hard money commercial construction loans can be higher-risk, so lenders want to ensure you’ll be a low-risk borrower.
To do this, banks and other lenders often pull your credit score and your business’s financial information, and may even ask for personal income verification and tax returns. For ground up construction loans, Eagle Commercial Funding doesn’t include income requirements or verification in the approval process.
Commercial Construction Loans Rates
Construction loans for investment properties often have higher interest rates than traditional mortgages. It’s common to find these commercial real estate rates between five to 18%. The better your credit history, business finances, and experience, the lower your interest rate will be.
At Revolution Realty Capital, you can secure a ground-up construction loan with a rate as low as 8.49%, funding up to 85% loan-to-cost (LTC), and 75% after-repair-value (ARV).
Types of Construction Loan Collateral
Since there’s no building to use as collateral in hard money commercial construction loans, you may be asking, “Can land be used as collateral for a construction loan?” or “How does using land as collateral work?”
Collateral is often required for loans as protection in case you fail to make payments. Construction loan collateral can come in the form of owned land or existing property.
In some cases, you can secure a loan against the equity in these assets. This loan can then assist with the down payment of your construction loan. The down payment amount will be determined using an LTC calculation.
Using land as collateral for a construction loan works best if you own the land outright. If you have a loan on the land, many lenders fold the existing land loan into your construction loan. However, land in this case isn’t strong collateral and might drive up your interest rate or increase other aspects of the loan. Depending on your lender, you may also be required to have both a contingency reserve and an interest reserve. These reserves act as additional protection for the lender if the project goes over the allocated budget or any unforeseen issues arise.
Land Loans vs. Construction Loans: Land loans are strictly for land purchases. If you don’t plan to build anything on the land soon, this may be a good option for you. However, if you plan to start building immediately, a construction loan that incorporates the purchase of the land would be a better choice.
| Collateral for Real Estate Construction Loans |
|---|
| Land Value – Owning the land you plan to build on reduces the lender’s risk of losing their loaned funds if something in the project goes south. |
| Existing Property – If you don’t own the land you’re building on, using a property you own as collateral can also be acceptable to lenders. |
| Contingency Reserve – Many lenders request you have a 5–10% contingency reserve to act as a safety net if the project goes over budget. |
| Interest Reserve – This account can hold the total interest over the life of the loan instead of the borrower having to make monthly payments. |