How Do Construction Loans Work?

David Cohn
Mar 29, 2021
Commercial loans

Have you been renting your shop or office space for a long time and want to buy your own building? Has your business outgrown its current premises and need to expand its existing space? Whatever the situation, many companies eventually need to invest in real estate as the next step in their growth.

Such an endeavor comes with a large price tag that most businesses can’t cover upfront. The solution is to take out a commercial construction loan.

Securing a construction loan for a commercial project is ever as easy as securing a loan for a home. It’s important that you understand its mechanics and what you can expect throughout the application process to increase your chances of getting approved.

This blog discusses how commercial construction loans work and demystify the construction loan lending process.

What is a construction loan for a commercial property?

Commercial construction loans are designed to cover costs associated with the renovation or construction of a commercial real estate structure.

Funds can be used to cover land purchase and development, renovations on existing properties, or labor and materials for construction when building from the ground up.

It is different from a commercial mortgage, which is used to purchase existing commercial real estate properties.

A commercial construction loan is used specifically for renovating an old real estate asset or building something new. The lender provides funds throughout the project as milestones are met.

How do construction loans work?

Commercial construction loans are structured so that you (the borrower) will NOT receive the full amount of the loan upfront.

Instead, you and the lender will create and agree on a draw schedule. Partial funding is released as the project progresses and new milestones are completed.

For example, you can get the first draw once the land is cleared and ready for building. The next draw might be released after the pouring of the foundation. The third draw might be released upon framing, etc.

Lenders typically require professional inspectors to confirm that each agreed-upon milestone is completed before releasing the money. This continues until all milestones are met, and the full amount of the loan is distributed.

As the borrower, you only pay interest on the part of the loan that you have received. Let’s say that the cost of your new commercial construction project is $5 million, but the lender has only released $1 million so far.

You’ll pay in interest only on the $1 million.Once the project is completed and the loan is due, you can choose to switch to a commercial mortgage, with a property serving as collateral.

You can use the funds from this commercial mortgage to pay off the construction loan. You’ll pay more affordable payments over a longer term with your new mortgage.

Some construction loans for commercial properties (like those provided by the Small Business Administration) provide longer-term options so that borrowers don’t need to take out an additional loan after completing the project.

What are the interest rates on commercial construction loans?

Expect to pay anywhere from 4% to 12%: the higher your credit score, the lower your interest rates (in most cases). The type of lender you choose to work with also determines your rate.

Commercial construction loans from traditional banks typically carry lower interest rates, whereas hard money lenders usually charge more. Depending on your lender, you can also expect to show their several fees associated with the loan, including:

  • Down payment
  • Guarantee fees
  • Documentation fees
  • Processing fees
  • Fund control fees
  • Project review fees

What is the down payment required for a commercial construction loan?

Commercial construction loans are considered higher-risk loans, so a sizable down payment is typically required. Prepare to shoulder anywhere from 10% to 30% of the total cost of the project.

Traditional banks use the loan-to-cost ratio to determine that a down payment is required. To obtain this number, divide the total loan amount requested by the total cost of the project.

So if you want to request a loan of $1.9 million for a project with a total cost is $2 million, the loan-to-cost ratio is 95%.Most lenders require an 80% to 85% loan-to-cost ratio.

The lender would end $1.6 million at 80% and $1.7 million at 85% for the example provided. As the borrower, you need to shoulder the remaining costs.

What do lenders look at when evaluating a commercial construction loan application?

Lenders consider several factors to determine the eligibility of a commercial construction project for a loan. Your credit score is one of the biggest considerations. Construction loans are high risk; understandably, many lenders want to work only with low-risk borrowers.

  • Credit score requirements differ by lender. Having a score in the high 600’s is the minimum requirement for SBA CDC/504 loans. Banks might require a minimum of 700. Your business credit score will also be considered.
  • Lenders will likewise look at your debt to income or DTI ratio, which shows how much your business income goes to repaying debt monthly. Lenders want to see a DTI of 43% or less. Some are stricter.
  • Finally, lenders will look at your debt service coverage ratio (DSCR), which shows on an annual basis how your business income relates to your business debt. A higher number demonstrates that your business earns enough income to cover new loans. Lenders want to see a 1.25 DSCR or higher.

Besides all these, lenders will consider your current business financials and overall industry experience to gauge your eligibility. They will ask for detailed construction plans, too.

There are cases when you might need to alter the plan based on specific risks from the lender’s point of view, so it’s important to be flexible.

What are the types of construction loans for commercial properties?

  1. SBA CDC/504 loan program: This loan issued by the small business administration is very popular with business owners needing construction loans. It offers competitive interest rates and lows down payment requirements.
  1. SBA 7(a) loan program: You can use this type of SBA loan to buy or construct commercial real estate. The maximum loanable amount is $5 million, and the terms are up to 25 years. A down payment of anywhere from 10% to 20% is required.
  1. Bank loans: Most banks ask for a down payment of at least 10%, and maximum repayment terms are pegged at 25 years. You can choose from a variable or fixed interest rates.
  1. Mezzanine loans: If your loan-to-cost ratio is low in you need to cover additional costs, you may look into a mezzanine loan. This kind of funding is secured with stocks. Lenders can convert to equity stakes when the borrower defaults.
  1. Hard money: Finally, it’s possible to obtain a construction loan for a commercial building project through private hard money lenders. They provide short-term funding and offer distinct advantages such as faster processing time and minimal upfront costs. The interest rates are higher because the lender is taking on more risk.