Securing a commercial construction loan for various types of commercial real estate can be a difficult process to navigate. This post will shed some light on commercial construction loans and demystify the lending process.
Commercial Construction Loans and Lenders
The construction loan process begins when a developer submits a loan request with a lender. Construction or development lenders are almost always local community and regional banks. Historically this was due to bank regulation that restricted trade areas for lending. More recently, life insurance companies, national banks, and other specialty finance companies have also started making construction loans. However, community and regional banks still provide the majority of construction financing, since they have a much better understanding of local market conditions and the reputation of real estate developers than larger out of area banks.
There are two normally two loans required to finance a real estate development project, although sometimes these two loans will also be combined into one:
- Short term financing. This stage of financing funds the construction and lease up phase of the project.
- Long term permanent financing. After a project achieves “stabilization” and leases up to the market level of occupancy, the construction loan is “taken out” by longer term financing.
When a bank combines these two loans into one it’s usually in the form of a construction and mini-perm loan. The mini-perm is financing that takes out the construction loan, but is shorter in duration than traditional permanent financing. The purpose of the mini-perm is to pay off the construction loan and provide the project with an operating history prior to refinancing in the perm market.
Commercial Construction Loan Underwriting
After the initial loan request is submitted, the bank typically goes through a quick internal go/no-go decision process. If the project is given the go-ahead by the bank’s senior lender, the lender will sometimes issue a term sheet which outlines the terms and conditions of the proposed loan, provided all of the information presented is accurate and reasonable. Once the non-binding term sheet has been reviewed, negotiated, and accepted, the lender will move forward with a full underwriting and approval of the proposed loan.
During the underwriting process the lender will evaluate the proposed project’s proforma, the details of the construction budget, the local market conditions, the development team and financial capacity of the guarantors, and in general address any other risks inherent in the loan request. Typical documents required in the underwriting process include borrower/guarantor tax returns, financial statements, a schedule of real estate owned and contingent liabilities for the guarantor(s), the proposed project’s proforma, construction loan sources and uses, cost estimates, full project plans, engineering specifications, and in general, any other documents that can support the loan request.
From an underwriting standpoint, one of the most notable differences between a commercial construction loan and an investment real estate loan is that 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 proforma. The credit approval process is similar to other commercial loans, but 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.
Once the commercial construction loan is approved, the bank will issue a binding commitment letter to the borrower. The commitment letter is similar to the term sheet, but contains much more detail about the terms of the loan. Additionally, the commitment letter is a legally-binding contract whereas the term sheet is non-binding.
Commercial Construction Loan Closing and Beyond
Upon completion of the loan underwriting and approval, a loan then moves into the closing process, which can take on a life of its own. Commercial construction loan closings are complex and involve an overwhelming quantity of documentation and procedural nuances. Typically the closing is handled by the lender’s attorney, the borrower, and the borrower’s attorney. A loan closing checklist is also 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.
After a loan closes, the loan mechanics are primarily the responsibility of the loan administration department within a bank. The loan administer (sometimes just called the loan admin), will fund the loan according to the internal policies and procedures of the bank. Commercial construction loans are typically funded partially at closing to cover previously paid soft and hard costs. After the initial partial funding, loan proceeds are disbursed monthly based on draw requests for costs incurred. These costs are submitted by the developer and verified by the lender.
Commercial construction loans can quickly become complex and difficult to secure. But understanding how construction loans work and how commercial developments are evaluated by lenders can help demystify the funding process. In future posts we’ll dive into various parts of this process in detail. In the mean time, if you have any specific questions about commercial construction loans, please let us know in the comments below.