14
Jul

Construction Financing | Tips

Construction financing for residential and commercial building construction can be both a bit confusing to manage as well as hard to locate.

The basic premise of construction finance is to utilize existing property value to leverage against borrowing funds to allow for building construction and property improvement.  As the value of the property increases, more funds can be advanced to complete the next stage of work.

Construction stages or milestones are based on a predetermined degree of work completion that would effectively increase the value of the overall property.  For instance, a completed basement is of more value to a property than a partial hole dug for the purpose of putting a basement in.

At each of the predefined stages of construction, the lender would either self evaluate the degree of completion, or ask a third party professional, like an appraiser, to validate the work performed to that point.  If the work to that stage is satisfactorily completed, the lender will provide a construction draw payment and work can begin on the next stage, repeating the same process.

Construction financing requires solid project management to make sure that 1) the project advances in an orderly fashion; 2) budgets are accurate and relate to construction financing loans arranged, and 3) the administration process required by the lender is well managed so that funds can be paid out without delay.  There are many risks to construction financing applications including:

1. The budget does not reflect the actual costs, causing the project to be left incomplete.

2. The work flow does not align properly with the construction stage schedule for advances, causing the project to have no further money available to complete the existing stage before future advances can be made.

3. Accidents, weather, or other unplanned events push up the costs of the overall project beyond the level of financing available.

As a result, construction loans can be hard to secure, depending on your financing profile and the specifics of the project you’re undertaking.

For a residential construction project where the house involved is a small to medium sized house, there will be more sources of financing available, especially if you have strong credit, an average to above average source of income, and a level of net worth that provides additional security to a lender.

As these elements of a borrower profile are reduced and overall project risk elements go up, the sources of available financing will go down.

For example, if a borrower wants to build a multimillion dollar residential home and has a strong credit profile, there will still be fewer lenders interested in this type of project due to its size and the amount of capital required.  More money in the construction process will lead to more complexity, and more things that can go wrong, pushing the project into a “no thank you” category for some lenders.  A less optimal borrower profile will result in still fewer lenders.

Borrowers also have to be very careful in their cash flow planning to allow for contingencies and to also remember that the lender will retain construction holdbacks and not likely pay for any type of retail or goods and services taxes associated with a construction project, so these need to be budgeted separately.

For commercial construction loans, the principles are basically the same.  However, due to the higher level of risk associated to construction projects, the available lenders are significantly less.

Construction projects for tenanted buildings can require certain levels of presold units or occupancy commitments not only at the beginning of the project, but at different stages of completion as well, further complicating the construction finance process.

Main line banks, credit unions, and trust companies will select construction projects to finance the same way they approve any type of personal or business financing opportunity and that’s based on very low risk criteria.

As a result, there are many construction loan requests that cannot be approved for what most would call “bank funding”.   And even though many of these projects are financially solid, they will still not qualify for lowest risk forms of construction financing due to the overall risk profile.

A large secondary market for construction loans is private lenders.  These lenders tend to charge slightly higher rates, but are also prepared to fund deals that do not have the same levels of security required by main line bank deals.  Private money is actually a major source of construction loans, especially in the commercial construction market.

And even though the private sources will charge more, the reality is that construction financing is only required for a short period of time, so the additional costs can still be manageable within the budget of the overall project.

Private funders may also provide greater flexibility than banks when it comes to construction financing applications.  For instance, privates may be more flexible on construction stage definitions and the requirements for qualifying for draws and advances.  Privates also can offer more flexible financing requirements where the private lender will provide finance up to 100% of the project costs, depending on the overall security position of the underlying property.

While construction loans are very common due to the amount of building that takes place every year, there is still considerable complexity and risk to manage.  Those who go into the process uninformed can experience significantly higher costs and even disastrous results if the project cannot be completed.

Before you start into a construction project requiring construction financing, you would be well advised to seek the assistance of a financing professional to help you locate the source of financing and related program that best fits your requirements.

OUTLINE OF CONSTRUCTION FINANCING SOURCES

While most contractors are generally not directly involved with the financing of a construction project, understanding the process of financing and how it relates to a construction business is extremely important. The following outlines many of the most common sources for obtaining construction loans.

Commercial Banks:
Commercial Banks make single-family short-term and a limited number of long-term loans. They are generally the largest construction lenders on multifamily and commercial projects. They also make short-term loans to mortgage banks and to real estate investment trusts (REITs).

Savings and Loan Associations:
Savings and Loan associations are the largest of all lenders of both construction and permanent or long-term loans on single family housing. They also make a considerable number of construction loans for multifamily residences such as apartment houses and condominiums.

Mutual Savings Banks:
Mutual Savings Banks are generally located within the northeastern United States. Their mortgage investments are generally concentrated in single family permanent mortgages. They tend to make only a limited number of construction loans, but do make long-term loans to mortgage bankers and to real estate investment trusts which in turn make construction loans.

Mortgage Banking Companies:
Mortgage Banking companies make a significant number of loans for construction and land development but are mainly intermediaries between borrowers and lenders.

Life Insurance Companies:
Life insurance companies do a minimum amount of temporary construction lending. Their principle commitments are long-term loans on commercial and multifamily projects.

Real Estate Investment Trusts:
These trusts provide long-term mortgages on commercial and multifamily projects and a limited amount of construction loans.

Government Agencies:
Approximately every sixth house built in the United States is financed by the GI loan program. The Veterans Administration (VA) makes construction loans on housing for veterans, their dependents, and other beneficiaries of deceased veterans. The Federal Housing Administration (FHA) insures mortgage loans made by approved lending institutions, however, FHA does not lend money.

Other Sources for Loans:
Finally, miscellaneous sources of loans which should not be overlooked include individuals, syndicates, service organizations, and Community Housing Authorities.