9 Keys to Construction Loan Funding Success By Barbara Leuin, Ph.D. Commercial Lending Expert www.sofiacapitalventures.com
Key Steps to Construction Loan Funding Success Most people think construction lending begins when a developer submits a loan application to a lending source. But really, the construction loan begins way before then. Ideally, as soon as a developer or builder conceives of a project, financing should be one of the first considerations. This article provides 9 Key Steps that take you through the entire construction loan process. By following these essential steps, you will have the opportunity to prepare correctly to obtain the financing you need to successfully complete your project. The 9 Key Steps are: 1. Know what kind of loan you need 2. Know what you re up against 3. Know where to go 4. Have a plan! 5. Make your application complete 6. Be ready to come out of pocket 7. Be prepared for scrutiny 8. Be realistic in your projections 9. Be ready for funding 1. Know what kind of loan you need Before we get started, let s agree on some basic definitions. There are a number of different kinds of loans that people call construction lending: Land Loans: for the purpose of holding and/or developing raw land so that physical structures can be built on it at some time in the future. Development Loans: for the purpose of developing vacant, raw land by adding infrastructure, securing zoning, and completing the preparation of the land so that it can be built on at a later time. Construction Loans: for the purpose of erecting one or more structures on land that has already been developed for building; usually requires all entitlements and permits in place. A construction loan is, by definition, a short-term loan. Upon completion of the construction and the lease-up of the property, long-term or permanent financing is used to retire or pay out the short-term construction loan. Permanent financing is usually not available until the property has stabilized. A property is considered to be stabilized when the occupancy rate approximates the average occupancy rate in the market for that property type. Page 1
Sometimes a lender commits to both types of financing in combination. This is called a mini-perm or construction-permanent mortgage. In this case, the lender is committing to fund the project from construction to market stabilization. TAKE AWAY: Different types of construction loans have different risk evaluations associated with them and therefore different underwriting requirements. Knowing what kind of loan you need and the loan underwriting process you will go through will help you prepare for successful loan funding. 2. Know what you re up against Development and construction loans are the most difficult types of commercial loans to fund because the collateral hasn t been built yet. This greatly increases risk for the lender because it s easier for the owner to walk away and leave the lender holding the property. Most construction loans are therefore full recourse. Construction lenders look for considerable financial strength on the part of the borrower, even up to a net worth that is double the amount of the loan being sought. Due to the higher perceived risk, a land loan requires a 50% down payment, or funds 50% Loan to Value (LTV). Development loans may go as high as 60% LTV, which means the developer is still bringing 40% down payment. Construction loans may typically go to 75% LTV, based on after construction value. There will often be a limit of 90% of the construction costs, as well, meaning that the builder is potentially paying up to 10% of the construction costs out of pocket. KEY UNDERSTANDING: Before the lender funds the loan, he needs to know that the builder has the ability, both legally and physically, to complete the project as planned. This involves a lot of analysis that goes beyond the evaluation of an existing commercial project that is fully occupied and generating income. Because this analysis is primarily based on projected values and costs, there is a need for thirdparty verification or corroboration of every assumption the builder is making. 3. Know where to go It is important for the developer or builder to have a funding source that is knowledgeable about his or her project. Local banks are often the first resource a builder/developer should try. Local banks understand the community and understand the growth patterns that are occurring in and around the local community, as well as the reputation of the developer. However, not all banks in the local community will make construction loans. Look for the locally owned, community-oriented, and smaller regional banks. Page 2
As the economy continues to improve, national lenders are taking a larger role in construction lending. Private lenders are also taking a larger role in construction lending. National lenders offer a breadth and depth of experience in underwriting construction loans, but will not necessarily be familiar with your specific area, so they are going to rely more on the objective evaluation of your project. INSIGHT: The advantage of working with a national lender is that they will have a broader loan base than your local lender, and may be able to offer you suggestions to improve your project based on this breadth of experience. 4. Have a plan! The best way to prepare for a construction loan is to have a detailed, specific plan. The plan should include the creative vision of the project as well as the financial projections and a profile of the team that will contribute to its success. The most important financial elements of your plan center on: The current value of the property, as is where is The construction budget The proposed completion value of the property The market stabilized value of the property The time (and cash requirements) to market stabilization The exit strategy While you, as the developer/builder want to make sure that all the physical elements are in place, including plat maps, ground preparation, utilities, materials, etc., your lender wants to know that all the financial elements are in place. You want to be able to show a clear path to increasing the value and profitability of your project by having identified all of the costs and identifying the marketing efforts needed to lease up or sell out your development. If you are a tract home developer, then your business model is slightly different than the investment model. Rather than occupy the newly constructed space with either tenants or your own business (resulting in market stabilization,) your goal is to sell newly constructed houses to residential home buyers. In this case, you must consider the market absorption rate, or rate at which buyers are closing on new homes in your area. This rate and timeframe, as well as the costs of construction and the retail price of finished homes will ultimately determine the value of your project in the lender s eyes. 5. Make your application complete When you first make a loan application, everything you tell the lender about the project and about yourself is considered stated. That means that you are making an undocumented declaration. When Page 3
you apply, lenders assume that you are prepared to document and substantiate everything you state in your initial presentation. Your initial application will include a short presentation about yourself and about your project. Lenders want to know who they are doing business with as well as have an overview of the project. In addition to your loan application, an initial presentation will usually include: An executive summary of the project (2-3 pages) A construction cost summary Pro forma financial projections or a projected cash flow analysis A preliminary draw schedule Personal financial statements for all project sponsors (usually owners with 20% or more share) Credit reports for all project sponsors (sometimes requested at this stage) Resume of the project principal and/or project manager Based on the information you provide initially, the lender will do some preliminary calculations as to the value of the property after completion, which determines the proposed loan amount. You will usually get a quick go/no go decision at this point. If the project looks feasible in the lender s eyes, you will be offered a Letter of Intent or Term Sheet from most lenders. This will spell out both the proposed terms of the loan and the conditions necessary to close. Some lenders do this in one step; others in two, separating out an initial LOI followed by a Commitment Letter. There is often some give and take at this stage. Keep in mind that ALL OFFERS TO FUND ARE CONDITIONAL until they close. Once the proposed terms are accepted, the lender will move forward with full underwriting. 6. Be ready to come out of pocket In working with private lenders, the borrower is responsible for all third-party expenses, including the appraisal and Environmental Phase One report, even though these reports belong to the lender. You will be asked for a deposit that goes toward some or all of these items: Legal fees incurred during due diligence Escrow processing Lender processing Title search Inspection fees Commitment fees Unlike banks that are able to absorb some or all of these expenses prior to closing, private lenders engage third-party professionals to perform various reviews that contribute to the underwriting process. As the borrower, you are responsible for delivering all of the documentation that substantiates your Page 4
initial loan application and presentation, even when the report supporting your loan is provided by a third party. Lenders also want to know that you are committed to them in advance of closing the loan. Fees and deposits are usually placed into an escrow account. If you perform your part and the lender fails to fund, these deposits are usually refundable. If you fail to perform your part, causing the loan to be un-fundable, then the lender keeps your deposit as liquidated damages. 7. Be prepared for scrutiny Once underwriting begins, you will usually be given a limited amount of time to provide full documentation on your loan. Make sure you have everything covered. It is important for you to raise any issues prior to underwriting. Keep in mind lenders don t like surprises! Construction loans are complicated transactions that will require representation by experienced legal counsel. Your attorney is a critical team member who can provide valuable insight into whether any of the loan requirements set forth in the commitment letter merit further discussion with the lender. At a minimum, you should consult your attorney at the time of your lender issues the commitment letter. In general, you can expect the lender to request detailed building plans; general contractors bids; cost projections; the construction timetable; copies of all local, state and federal approvals; pre-leasing information; and a three-year financial history for all companies and principals involved in the project, including, but not limited to, company and personal tax returns. You can expect the lender to order a detailed financial evaluation/appraisal analysis (including a feasibility analysis), site-environmental testing and other project-specific professional reviews, at your expense. Your construction budget is one of the keys to making your project successful. Make sure you budget enough. These are the basic items that you should include: Actual construction costs (materials and labor) Project management fees Reimbursement for land owned free and clear (or retirement of debt on land already owned) Reimbursement for outlay of funds already incurred for entitlements, land development, permitting Contingency fees Page 5
Interest Reserves Loan Closing Costs Be prepared to document your budget with third-party evidence, such as contractor s bids and engineering estimates. It s important to build interest reserves into your budget since there is no cash flow from the project during construction. On large projects construction lenders will compute the actual anticipated interest expense and use this figure in the Interest Reserve. On smaller projects, however, the construction lender will merely assume that only 50% to 60% of the construction loan on average will be outstanding. Some builders are not aware that you can include management fees and reimbursements for expenses already incurred. They will also allow a margin for contingencies. Most construction lenders will also allow you to include closing costs and loan fees in the construction budget. REMINDER: make sure that all of your assumptions are identified, and then well documented. 8. Be realistic in your projections The purpose of underwriting is for the lender to fully verify that the information previously stated by the borrower is correct and that the assessment of risk is within the parameters set forth by the lender s program guidelines. With a construction loan there is no operating history to underwrite. The economics of the project, and thus the valuation of the property, is based solely on the real estate pro forma. Because of the additional risks inherent in construction loans, further consideration is given to the development team and general contractor, as well as the prevailing market conditions. The underwriting process is where the heavy lifting in the decision-making process is done. It will be critical that the independent appraisal and market feasibility study validate the value of the finished project and the underlying assumptions supporting the project plan. For example, will lease-up take longer than originally expected, or will it be on plan? A longer lease-up period would increase the carrying costs of the construction loan and, hence, the total cost of the project. Will the market support your projected rent levels? Any of these factors and others could impact the overall cost of the project or the project s ability to make its debt payments and perhaps put the lender s approval in question. Make sure your assumptions are realistic. 9. Be ready for funding Upon completion of the loan underwriting and approval, a loan then moves into the closing process. Typically the closing is handled by the lender s attorney, the borrower, and the borrower s attorney. A Page 6
loan closing checklist is normally issued to the developer along with the commitment letter, which outlines in detail what needs to be completed before the loan can close and funding can begin. As the closing date approaches, the lender s counsel or closing agent will circulate draft loan documents and afford your attorney the opportunity to review and revise them after consultation with you. In addition to standard commercial loan documents, the construction loan agreement spells out the conditions that must be satisfied prior to the lender advancing the needed construction funds in stages over the course of the construction. These controls on advances are part of an effort by the lender to devise and enforce safeguards against risks that are inherent to construction loans, such as increased construction costs, weather delays, and unscrupulous or substandard contractors. After a loan closes, the loan mechanics are primarily the responsibility of the loan administer or loan servicer. Prior to any final disbursement of the balance of the loan proceeds, the lender will require a certificate of completion from the architect, a copy of the certificate of occupancy issued by the municipal building official, and an as built survey showing the constructed improvements upon the land. Final words of advice From a lender s perspective, the value of the collateral granted as security in a construction loan depends on both the successful completion of the construction and the realization of the projected economic value of the completed project. The lender makes every effort to protect itself from difficulties that may arise during construction, such as unsatisfactory work, delays in construction, violation of building codes, failure to administer subcontracts properly, and diversion of funds for other purposes. While the advance conditions imposed by the lender are reasonable in light of the risks undertaken, they do result in additional burdens on you, the borrower. Having an organized approach with the assistance of capable professionals, such as your loan officer, your attorney, your contractor and your architect, the construction financing process can be very manageable and contribute to the successful completion of your project. * * * Sofia Capital Ventures facilitates private commercial lending for construction and nonconstruction projects. The company has developed considerable experience and expertise in the construction loan process. If you are new to construction lending and would like someone to advise you as to the best way to receive funding for your proposed project, the commercial lending experts at Sofia Capital Ventures are available Page 7
to assist. While we do charge nominal fees up front, all consulting fees are rebated fully at loan closing. We stand behind our work. Give us a call today to get started. * * * Info@SofiaCapitalVentures.com REFERENCES 1. Robert Schmidt. How Commercial Construction Loans Work. August 20, 2013. http://www.propertymetrics.com/blog/2013/08/20/commercial-construction-loans/ 2. Commercial Construction Loans and Computing the Interest Reserve http://www.cloans.com/educational_pages/construction_loans/computing_interest_reserve.html 3. Dave Barry and Jay McGuinness. What to Expect When Seeking Financing for a Commercial Construction Project. http://ctinnovations.com/resource/38 Page 8