Put simply, a construction loan is used to finance building a new structure or to complete extensive renovations on an existing one. However, it's important to note that commercial construction loans function much differently than traditional mortgages. With that in mind, this article will cover what a construction loan is, how they work, and the different types of commercial construction loans that are available. Keep reading to learn more.
What is a construction loan?
As the name suggests, a construction loan is a specific type of loan used to finance a construction project for a new home or building. Typically, these funds are used to purchase and develop new land, to cover the materials and labor costs associated with building a new structure, or to do a large-scale renovation on an existing property.
Often, the construction cost for building a new structure from the ground up can be expensive. In fact, when you're looking at building a commercial structure like an office or apartment building, these costs can add up to hundreds of thousands, if not millions, of dollars. Since few businesses have that kind of cash flow on hand, construction lending is used to provide businesses with the funds they need to build these structures from the ground up.
How do commercial construction loans work?
It's important to note that construction financing works a little bit differently than a traditional mortgage loan that you might take out to buy your primary residence. With that in mind, we've laid out some of the key differences below so you'll have a good idea of what to expect when you're ready to talk to a lender about securing some financing of your own.
Allocation and payment structure
The biggest difference between a construction loan and a traditional mortgage is the way that the allocation and payment are structured. With a home loan, the entire loan is paid out in one lump sum payment at closing. Then, the borrower is responsible for making a monthly payment towards both the principal and interest until the loan is paid off in full over the course of many years.
In contrast, a construction loan is paid out using a draw schedule. With a draw schedule, the loan is paid out incrementally as the construction project hits its projected milestones. For example, a project's first draw might be for the purpose of purchasing and developing the land. Then, after an inspection, the lender might release another draw for the purpose of buying some initial materials and hiring labor.
Notably, the borrower doesn't have to make payments on the principal amount until the loan has been fully paid out. Instead, they only pay interest on the amount that they've received to date during the draw period. The full principal payment usually comes due when construction has been completed, at which point the borrower usually takes out more permanent financing to replace the construction loan.
The interest rate you'll receive on a commercial construction loan will typically be higher than you might find with a traditional home loan. While they will vary, depending on factors like current rate trends and the borrower's financial history, it's common to see rates fall anywhere from 4% to 12%. Typically bank loans offer the lowest rates while alternative sources like hard money lenders often charge a premium to access their financing.
Additionally, construction loans have a few fees that you likely won't see with a standard mortgage. These fees are typically added in with the rest of your closing costs and they are as follows:
- Documentation fees.
- Project review fees.
- Fund control fees.
- Guarantee fees.
While the down payment on a standard mortgage can often be as little as 3%, the expectation for a commercial construction loan is that you'll have a little bit more money to bring to the table. Expect there to be a down payment requirement ranging from 10% - 30%.
What types of commercial construction loans are there?
Now that you know a little bit more about the loan terms you'll encounter when you're ready to apply for a commercial construction loan, it's time to take a look at the various construction loan options that are on the market. We've summarized each type of commercial construction loan to make it easier for you to know which type you need. Keep reading to learn more.
- Land development loan: Land development loans are for the purpose of purchasing and developing land. However, they can also be used for installing things like water, sewer, and power lines on the construction site.
- Acquisition and development loan (A&D): An acquisition and development loan is usually used on land that has yet to be developed. As the name suggests, this loan allows you to take out the cash needed to both purchase the land and develop it. Sometimes this loan is also used to cover improvements on the infrastructure of existing buildings.
- Mini-perm loan: A mini-perm loan, also known as an interim loan, is usually used to cover the costs of labor and materials during the construction period. It usually lasts anywhere between 18-36 months and gets paid off in full once a permanent mortgage loan can be secured.
- Takeout loan: A takeout loan is another name for the permanent mortgage loan put in place after any short-term financing runs out. For projects that are considered particularly risky, the lender may require the borrower to secure a takeout loan before granting their request for the mini-perm loan.
Applying for a commercial construction loan
Finally, similarly to a standard mortgage, this loan process requires a lot of paperwork. While every construction loan lender will have their own requirements, here's an overview of the documentation that will be required for loan approval:
- Business and personal financial documents: Your loan officer will likely ask for a host of business and personal financial documents, including tax returns, a profit and loss statement, and a business plan. Additionally, they'll probably ask permission to pull your credit score.
- Construction plans: The more detailed construction documents you can give your lender, the better your chances of getting approved for a loan. At a minimum, they'll need to see building plans and contractor bids.
- Proforma: In commercial real estate, a proforma is a document containing financial projections for the business once construction on the building is complete, including the return that the developers are expected to achieve.
- Appraisal: Lenders often require an appraisal before approving the loan so that they can ensure it will at least be worth the value borrowed once it's been built.
The bottom line
Though they are both types of financing, construction loans function very differently than traditional mortgages. With that in mind, use this as your guide to commercial construction loans. Armed with this knowledge, you should feel prepared to go talk to a loan officer about your loan options.