Why Construction Loans Aren’t Always the Same – And What to Know Before You Get One

Why Construction Loans Aren’t Always the Same – And What to Know Before You Get One
Topics Commercial Real Estate

While the past year has posed many challenges, it has also presented several opportunities for developers and businesses to identify new avenues for both residential and commercial building. For example, many sectors like life sciences, grocery and multifamily have seen an increase in construction activity over the past year due to the current climate and needs of communities.

There are many types of loans to consider, from those that will allow immediate development to others that help facilitate the purchase of land while the rest of the project’s pieces fall into place. Whether this is your first construction loan or you are looking for new ways to leverage capital for an improvement or expansion, it is important to understand the specifics behind these loans to determine what is right for your needs and how to ensure you have the right partner.

Here are some considerations to keep in mind as you determine what is best for you and your project.

How do construction loans differ from traditional loans?

With a traditional loan you receive the lump sum of the loan when you close, while a construction loan will be dispersed over the length of the loan term on an agreed upon schedule. In accordance with the loan schedule, bank inspectors will come out to ensure the project appraises and is being completed according to schedule, and the next amount will be distributed.

The typical construction loan term is 24 months or less, whereas you may have several years to pay off a traditional loan.

A construction loan cannot be used for private homes, which are facilitated through mortgage or private banking services.

What are the different types of construction loans?

Commercial construction loans are used for finances associated with the construction or renovation of commercial buildings or residential developments. The loan amounts are typically above $2 million to up to $20 million. They can be larger or smaller, however, based on the scale of the project.

An acquisition and development loan uses a portion of the funds to purchase property, with the remaining funds used for hard costs like materials and labor for improvements needed for development on the property.

Banks like WSFS also offer bridge loans, which give borrowers financing to acquire a project or land and affords the time to get plans in place. These loans can be especially helpful if a borrower wants to secure land or a property but finds that it is simply not the right time to build based on several factors. This trend was apparent in the past year as many projects went into ‘wait-and-see’ mode as COVID continued to impact both ongoing and new projects.

What do I need to get approved?

A lending partner will look at the strength of a borrower by analyzing the loan amount against the borrower’s equity. Your lender may have a specific figure in mind or requirement for the loan-to-cost ratio, ensuring the value of the project or land is an ample percentage of the full loan amount (typically 65%-75%). They will also consider other factors like capital structure, credit score and debt-to-income ratio.

To get approved, be prepared to have your business plans as far along in the process to paint an accurate picture of the funds needed and a 20-25% minimum down payment. Your lender may also recommend a different type of loan during your conversations, dependent upon where you are in the planning process to help you take the first step (i.e. securing land) while other pieces fall into place, like securing labor or equipment.

How to identify the right partner

As with other lending options, you may want to shop around to identify better rates or consider other relationship factors. You’ll want to find a partner that will honor your terms sheet and move quickly to ensure you can stick to your timeline. Rates can change, as can the price of materials. We have seen this occur with lumber and other building materials over the past several months, so time is of the essence. Ask your lender specific questions about the terms sheet and appraisal process to ensure you have the necessary time to get affairs in order.

Managing this process is greatly benefited by leveraging a local partner with a deep knowledge and understanding of the market and regional trends.

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