Construction Loans: Questions and Answers

It would seem that construction activity is still fairly high based upon the number of calls that I get from people about construction loans.  There are a lot of calls from people just getting started, as well as from a number of seasoned “construction veterans.”  In a large number of those calls, I hear some common questions.  So I thought that I’d answer a few of them here.

Q:  How do construction loans work?

A:  In general, just like every other loan.  You sign loan documents and money is funded into escrow.  In the case of a construction loan, only a portion of the total loan is released.  The balance is released either in preset “stages” or as workers complete portions of the project according to a budget.  The former is called a “draw” system and the latter is called a “voucher” system. 

Q:  How are the payments calculated and who makes them?”

A:  Commercial loans have the added security of an income producing property providing the funds to pay the loan payments.  For residential loans, it’s the borrower’s income.  When a property is being built, there is no secondary source of repayment so the burden of payment would normally fall to the borrower.  But lenders didn’t want borrowers to use up all of their funds in case something went wrong with the project, so they created “interest reserves.”  This is a chunk of money set aside in the loan to do nothing but make the loan payments during the construction process.  The payment is based upon how much money has actually been used or “drawn” at the time the payment is due.  This is not the case for private money lenders.  They calculate interest on the entire amount of the loan from the initial funding date.

Q:  What’s a contingency reserve?

A:  This is another chunk of money set aside in the loan to protect you against cost overruns.  Since it can take a year or more to complete a project, the prices used to estimate the construction budget become less accurate as time marches on.  The contingency reserve is released a little bit at a time during the construction process to cover inevitable price increases.

Q:  How do you calculate the maximum construction loan?

A:  The maximum construction loan is based upon many factors:  Property type, stabilized value at completion, total costs, and equity invested to name a few of the key concerns.  For any given property type, there is usually a maximum “loan to costs” and a maximum “loan to value.”  The key is this:  The largest permanent loan for which the property can qualify, assuming it is built and fully occupied or valued, will limit the construction loan.  This is because the construction lender wants to be paid off at the end of construction and the way to do that is with a permanent loan.  This does not mean that if the permanent loan exceeds the total costs of the project that you can get 100% construction financing.  Just about every lender is going to look for 10% to 20% of the total costs to be funded by equity or cash from the borrower.

I hope that these few examples clarify some of the questions that you might have concerning construction lending.  I’ll cover more here in the future.  If you should have a question that wasn’t covered, email me at your convenience and I’ll do my best to give you a complete answer.