The Basics Of Construction Financing -A Primer

securing smarter and better construction financing has been one of the primary challenges the nations real estate investors and contractors face. This tutorial will give you the basic key knowledge to help you overcome the challenges  that real estate financing and especially on the construction side, create. .  This tutorial will give you key knowledge to help overcome the challenges that will face you as your big ideas turn into reality.

The tutorial was written for owners in the private sector who are not familiar with construction finance and that may need to secure funding. 

In this tutorial we will cover five primary topics:

I.  The basics of construction finance
II. How to get financing and prepare documentation for lenders
III. The kinds of financing available and strategies for securing funds
IV. The advantages and disadvantages of different financing strategies and
V. Specialty financing sources for the biggest projects

1. THE BASICS OF CONSTRUCTION FINANCING

In this section, we cover the way construction loans work, project costs and the key numbers that your lenders will evaluate.

HOW CONSTRUCTION FINANCING WORKS

The first thing to know about construction financing is that you actually need to fund two different loan periods, each one that has a different risk levels. Most owners secure two loans, one for each part of the development process. The first is the period during the construction phase, this phase is funded with a construction loan. The second loan is the period once construction is completed, funded with a permanent loan, AKA a takeout or permanent loan.

Ground up construction financing

CONSTRUCTION LOANS

A construction loan pays for up-front project costs. In most cases, you’ll make interest-only payments during construction, meaning once construction is complete, you’ll still have to pay the full principal amount of the loan plus interest. The faster you complete construction, the less interest you’ll have to pay, or the lower your cost of capital.

STABILIZATION

Once your construction is completes, you will need your financing facility to reach what’s called stabilization, which happens when your project/ facility is worth more than the initial cost of construction. Lenders see your finished project as quality collateral, so that lending to you is less risky. Depending on the type of property that you build, it may not achieve stabilization until your project has reached a specified level of occupancy or stablization.

STABILIZATION:  
When property value is greater than 
the initial cost of construction

PERMANENT LOANS POST CONSTRUCTION

ground up construction

Once your investment property has achieved what is known as stabilization, you will want to get a permanent loan that has a lower interest rate and a longer term to pay off the construction loan. 

Then, you’ll pay back the construction loan, which typically has a set longer term repayment structure and specific schedule.  For certain construction loans you can take out a loan that covers both the construction and converts post construction to a stablized longer term loan.  In a combination loan the conditions to achieve stabilization are typically defined up-front, with a pre-negotiated interest rate and also a payment plan that kicks in once that stabilization is achieved. 

One of the most favorable loan options would usually be a low-interest rate balloon loan, in which investment owners make very low monthly payments (possibly interest-only) typically for a specified time period and then make a large or balloon final payment. Because of the tight financial markets today, balloon loans are difficult to come by.

FINANCING BASICS: RISK, COLLATERAL AND VALUE​

Loans that are made for construction in particular new construction has much higher risk that many other types of real estate lending.  To begin with construction is a very complex undertaking with a lot of moving parts and potential problems that can be encountered along the way. New construction requires an experienced or financially capable investment team that has a defined plan from beginning to stabilization or sale.   

In addition it requires an experienced project team to oversee and deliver your construction on time, within your budget and to the high standards required. Your financing partner or  lender wants to know that your project will succeed so every measure to evaluate the potential success of your project. 

PASSING THE PROFIT TEST: UNDERSTANDING WHAT YOUR LENDER LOOKS FOR

#1 LOAN-TO-VALUE RATIO 
Amount of money borrowed vs. estimated value of Invesment

When your lender is evaluating a potential borrower for a construction loan, your lender will begin with what is know as the  profit test.  The “profit test” will make an assessment of whether or not your finished construction investment will be worth more than the cost of your project. Believe it or not if there is no profit for you above the loan, your lender will more than likely not make the loan. You also do not want to risk losing your project to the lender, hence the profit test.  

Your lender will not only evaluate how much construction experience your ownership group has and the experience of your entire team overall. They will also consider how invested you are in your construction project using two different formulas: 1.The projects loan-to-value ratio and # 2.The loan-to-cost ratio.

#2 LOAN-TO-COST RATIO 
Amount of money borrowed vs. cost of project

In the given lending climate your loan to value may be maxed at 75% of a projects value. Check with www.CambridgeHomeLoan.com who has access to the highest loan to value rates in the market today. For fix and flip and certain construction types we have achieved 100% financing on the construction portions of the loan.  The lower the LTV and LTC (loan to cost) ratio, the less risk to the lender and the least likely you will have to use a personal guarantee or the need to put up additional collateral.

COLLATERAL AND GUARANTEES

In almost every construction loan, owners use their investment or property as collateral. If the owner defaults on the construction loan, the lender gets the investment. Depending on the type and size of the project, the land may be the biggest portion of collateral that the lender has as security for the loan. For an office property the lender can lease the space to multiple tenants, a gas station can only be leased to one type of tenant making it riskier.  In almost every case today your lender will require the principals to provide personal guarantees. 

A personal guarantee will require the principals that sign on the loan to be personally responsible to pay back the loan if the project fails.  During the underwriting of your construction loan the lender will evaluate the net worth of the principals to see that they can cover the cost if the project does fail. This is known as the loan to size ratio. The principals with submit personal financial statements showing their assets and liabilities and may also be required to provide and annual update to the lender. The guarantee is typically capped. The guarantees may be required by all of the principal parties. 

DEFINING STABILIZATION & HOW LENDERS VALUE YOUR PROPERTY

To get a permanent loan, you’ll need a valuable facility that’s achieved stabilization and a venture that’s making more money than you owe. Lenders measure this primarily using your debt service coverage ratio, or DSCR (see sidebar for definition). Any DSCR number greater than 1.0 means the property is generating enough income to cover its debt (NOI is greater than debt service). And that’s what lenders require. In fact, many lenders want to see a DSCR of 1.25 or better. A ratio greater than 1.25 can help you get not only a permanent loan, but also secure a more favorable interest rate. 

Lenders will usually also require your business to have a positive cash flow. This means having a net income greater than all expenses, including tax write-offs, depreciation and interest. Lenders want to see that your property achieves a value greater than the cost of construction. While several measures are used to value a property (location, value of similar properties, cost for repairs, etc.) lenders primarily define value as the amount of income you earn divided by your rate of return in operating your facility. Though these formulas may appear daunting, just remember they’re all tools for testing one thing: whether or not your project will be profitable.

[DSCR] DEBT SERVICE COVERAGE RATIO =
NOI (Net Operating Income/
_____________________________Total Debt Service

NOI (Net Operating Income/
Annual operating income from your property – the cost of operations (not incl. tax write-offs, depreciation & interest). 

DEBT SERVICE
=
total money owed from construction loan (principal plus interest) 

PROPERTY VALUE = NOI/
Capitalization (Cap) rate

CAP RATE= rate of return on an investment property

BASICS OF INTEREST RATES

Construction loan interest rates fluctuate along with market interest rates, which are largely determined by the Prime rate and the LIBOR rates. A fair construction loan interest rate is typically the Prime rate plus one or two percent.

THE FOUR MAJOR TYPES OF A CONSTRUCTION PROJECTS COST

When planning your project and asking for loans, you’ll need to account for four different types of costs:
1.Hard costs
     a. Your direct construction labor and materials costs
2.Land costs
     a. The cost of acquiring land and property— sometimes, land costs are considered soft costs
3.Soft costs — all the costs you don’t see
     a. Permitting
b. Architectural design
c. Engineering
d. Taxes
e. Insurance (liability, builder’s risk, title policy and contingency policy, among others)
f. Construction bonding, testing and inspections
g. Developer’s fee or broker’s commission
h. Appraisal and legal fees
i. Interest on construction payments
4.Contingency reserve
     a. You must keep a reserve fund at all times to make interest payments and keep your project solvent
b. Lenders may require you to keep a certain reserve level, typically 5 percent of soft costs

Please consider all of these costs and factors prior to applying for a construction loan. Your lender is just as interested in your success as you are. Lenders have no interest in taking back real estate and prefer that you are successful and remain a customer for years to come.