New building projects in commercial real estate are notoriously high-risk investments (e.g., value-add, buy-and-hold, etc.). However, the ROI on a new project may be far higher. For this reason, we get a lot of inquiries about commercial development financing. This piece will detail the steps necessary to secure financing for a commercial building project.
Here are the details of what we’ll discuss:
- A Guide to Commercial Construction Loans
- The Procedures Needed to Acquire a Commercial Building Loan
- Conclusion
A Guide to Commercial Construction Loans
Before discussing how to apply for commercial construction loans, we first need to define these loans. Aside from the fact that every lending institution has its policies and procedures, this type of financing can fundamentally be distinguished by one, two, or all three of the following characteristics:
Short-Term, Interest-Only Financing
Construction loans can obtain short-term finance, typically from six months to three years. Furthermore, interest rates on construction loans are typically higher than those on permanent mortgages because of the additional risk involved. These rates are typically tied to an arbitrary index and fluctuate over time (e.g., LIBOR, COFI, etc.).
However, unlike permanent mortgages, interest-only payments on commercial construction loans are the norm. In this way, builders may finance their projects while keeping their cash needs to a minimum when the property is not generating any income. An interest reserve term is typically built into most contracts, during which the developer pulls from the outstanding loan to cover interest expenses. The developer will then switch the construction loan to a permanent mortgage after completing the building process.
No “Pre-Approval” – Deal-by-Deal Basis
Smart home buyers are pre-approved for mortgages before they start browsing for properties. Unlike residential construction loans, commercial construction loans do not have a similar process. Given the one-of-a-kind nature of most business transactions, a lender cannot universally pre-approve a borrower for funding. Instead, borrowers must submit a comprehensive application package tailored to a unique transaction. Submitting this paperwork will result in a lending decision from the lender.
Draw-Style Disbursement – No Lump Sums
Commercial construction loans, like home loans, do not often provide funding in one large sum. Lenders often distribute payments in stages, called “draws,” to spread their exposure. The developer will draw requests to pay the general contractor for work as it is completed at predetermined project milestones. Should the contract fall through, the lender will lose only the incurred construction expenses and not the full loan amount. Lenders can, in theory, recover their loans in full through the foreclosure procedure, regardless of the state of construction.
The Procedures Needed to Acquire a Commercial Building Loan
Step 1: Verify the Overarching Financing Prerequisites of a Commercial Lender
As previously indicated, the standards and processes for loan approval will vary slightly from one lender to the next. Although you won’t be able to get pre-approval for a construction loan, it’s still a good idea to get to know a commercial lender before putting in an offer. That way, you’ll be prepared with the proper documentation for your building loan application.
And even though you’re looking for business financing, most commercial lenders want to see proof of your finances (often in the name of an LLC). It is the first phase, during which you can gather and submit this info to the lender.
Step 2: To Make an Offer on a Piece of Land
The land is essential for every building endeavor. This step is unnecessary if you already have a property for future development. Otherwise, you’ll have to make a bid. Assuming the land is zoned for the type of commercial development planned (e.g., light industrial, commercial, mixed-use, etc.). If not, the closing will be conditional on the approved zoning change, as the re-zoning contingency is included in the purchase offer.
There will be a feasibility period clause in the purchase offer as well. Developers can verify a project’s financial and construction viability after making an offer.
Step 3: Affirm the Design and Contractor Quotes
For instance, prospective buyers can commission architectural drawings at the feasibility stage. The architect will subsequently hold a formal bidding process to have general contractors bid on these plans. After assisting with the evaluation of bids, you and the architect will do one of
two things: A) choose a general contractor for the project, and B) obtain comprehensive construction cost estimates.
Step 4: Underwrite the Transaction
The developer can underwrite the deal once they have architectural plans, acquisition, hard construction expenses, and associated soft costs. Underwriting is the process of analyzing the financial aspects of a purchase. If the property is stable, will the rental revenue cover the expenditures of maintenance and debt repayment? Is the construction loan debt going to be paid off with the valuation of a fully active and stabilized business?
Step 5: Send the Commercial Lender the Financing Package
If the project passes underwriting, you will send the final construction financing package to the lender. All of the requirements mentioned earlier, and those unique to the given offer, will be part of this. While the specifics of each transaction are unique, the following documents are typically requested by lenders:
- Project team (architect, GC, property manager, etc.)
- Site information (survey, zoning information, environmental maintenance work if required, etc.)
- Estimated construction expenses and a timetable for the project’s completion
- Financials for the GC
- The stabilized pro forma for the property
Step 6: Close the Deal
As mentioned earlier, the loan will be reviewed by the lender after it is submitted. Due to their due diligence, the lender will likely have queries and request extra information.
You will eventually be permitted to complete the transaction. At the closing, you will sign the documents about your loan, make the initial payment, and pay any other costs associated with the transaction. After the transaction has been finalized, the first draw from the lender will be issued so that the borrower may begin paying for items such as purchasing land and having construction begun.
Conclusion
It is easy to understand why inexperienced real estate investors might be reluctant to plunge into a significant commercial construction project alone. However, this does not mean that you cannot make a profit from investing in such businesses at the appropriate time.
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