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You have an idea for what you want to build, but you need to find a suitable location. Or maybe you have a certain location in mind and need to figure out what kind of commercial enterprise that area would be most suited for and what things to consider while dealing with commercial construction loans. You understand that once those parts are in place, you’ll need to create specific plans and submit them for approval to various municipal committees or agencies, such as the inland wetlands commission, or planning and zoning commission.
You’ll also need to start considering funding options for your project. You’ll be ready to start talking to potential lenders about funding once you’ve figured out some ballpark project costs and gathered some basic project details.
Top Things to Consider While Dealing with Commercial Construction Loans
Approach a Specialized Development and Construction Lender
The initial stage in the project financing procedure is to contact a commercial or private specialized construction lender. New construction loans, from the lender’s perspective, represent a higher level of risk. There is no operating history to rely on, unlike a traditional business mortgage. As a result, commercial building loans are usually considered by institutional or private lenders that are well-versed in their respective sectors. It would be exceedingly risky for a lender to take on both the construction loan and lease-up risks if they did not understand the intricacies of real estate development loans or local economies.
By definition, a “construction loan” is a short-term loan. Its objective is to cover the costs of constructing a building as well as the interest on the loan during construction and the initial lease-up period.
After the building is finished and the property is leased, long-term or “permanent finance” is utilized to pay off or retire the short-term construction loan. Permanent finance is typically not available until the property has reached a certain level of stabilization. When the occupancy rate of property approaches the market’s average occupancy rate for that property category, it is deemed stabilized.
Lenders will sometimes commit to both types of financing at the same time. A “mini-perm” or “construction-to-permanent” mortgage is what this is known as. In this situation, the lender has agreed to finance the project from start to finish, from construction through market stabilization. After the construction/stabilization stage, which is normally between 18 and 24 months, there are built-in procedures in this type of loan structure that allow the loan to term out or begin amortizing on a monthly basis. After converting to a permanent mortgage, the construction-permanent mortgage will typically amortize over 20 or 25 years, with a balloon payment upon maturity of 10 to 15 years.
Lender Review and Underwriting Processes
A bank or lender will frequently only want general project specifics in the early stages of your funding request. Borrowers are often required to submit detailed financial statements, personal tax filings, or detailed project plans. The lender is normally focused on assessing a basic sketch of the project, the project cost, summary predictions, and underlying assumptions, and the background of the project developers at this preliminary review stage.
A lender’s decision to reject a project after a preliminary examination is not uncommon. There are a variety of reasons why a lender may decide not to proceed with a project, regardless of its feasibility. A lender may have numerous existing construction projects in its portfolio and be unwilling to take on another, or the project may be too large or small for the lender.
A nonbinding term sheet or LOI (letter of intent) will be issued if the lender intends to proceed with the project. The term sheet lays out all of the terms and conditions that the lender is offering. At this stage, there is sometimes some wiggle room where you, as the developer, may request improvements that the lender may or may not agree to. The loan request will move into the underwriting step if you and the lender agree on the proposed terms.
The underwriting stage begins the lender’s collection of thorough information on the project and the project’s principals. In general, the lender will ask for detailed building plans, general contractor bids, cost projections, the construction schedule, copies of all local, state, and federal approvals, pre-leasing information, and a three-year financial history for all companies and principals involved in the project, including, but not limited to, corporate and personal tax returns. At your expense, the lender will likely request a comprehensive financial evaluation/appraisal investigation (including a feasibility analysis), site-environmental testing, and other project-specific professional assessments.
The underwriting phase is undoubtedly where the decision-making process’s heavy lifting takes place. The value of the finished project and the underlying assumptions supporting the project plan will be validated by the independent evaluation and market feasibility study. Will lease-up take longer than expected, or will everything go according to plan? A longer lease-up time would raise the construction loan’s carrying costs and, as a result, the project’s final cost. Will your forecasted rent levels be supported by the market? Any of these elements, as well as others, could have an impact on the project’s overall cost or capacity to make loan payments, perhaps jeopardizing lender’s position.
As a potential borrower, it’s critical to learn about the timeframes that your lender normally demands for loan approval. Early on in the process, timing details should be discussed. “How long will it take you to issue a commitment letter from the moment you have all the information you need from me?” is the ideal way to start a conversation with your lender. You’ll want to keep track of the processes involved in getting a loan approved, as well as how long each one typically takes. Loan/credit analysis, supervisory approval, loan committee(s) approval, issuing of a commitment letter, and loan closing are the steps in the process.
Construction loans are complex transactions that should be handled by qualified legal counsel. It’s vital that you hire a reputable business transaction attorney to represent your interests in this transaction. Your attorney may or may not be the same person who advised you during the municipal permission process or the early stages of the project while you were negotiating construction agreements with your contractor(s). Regardless of who it is, the attorney you will be using in the loan transaction should be consulted as soon as your lender issues the commitment letter. If any of the loan requirements in the commitment letter need a further conversation with the lender, your attorney can provide useful information. Most lenders are open to change requests as long as they are commercially fair and fall within their internal approval guidelines. Because the lender’s counsel will prepare loan documentation based on the commitment letter’s outline, it’s critical that you voice any concerns before the commitment letter is signed.
Loan Agreement and Closing
Following the execution of the commitment letter, the lender’s attorney will send you a closing checklist with a set of due diligence papers that you and your attorney must furnish prior to closing. A title search of the mortgaged property, a Uniform Commercial Code (UCC) filing, a judgment lien and bankruptcy search of the borrower and any guarantors, evidence of insurance covering the mortgaged property (including builder’s risk coverage during the construction period), and entity information for any borrower or guarantor, such as bylaws or operating agreements, certificates of legal existence, articles of organization, and authorizing resolutions are typically required. Your lawyer will assist you in gathering the necessary information.
As the closing date approaches, your attorney will get draught loan documents from the lender’s counsel, which he or she will evaluate and change after consulting with you. Your lender will require some additional documents due to the construction financing component of the transaction, in addition to those loan documents that are commonplace in a commercial real estate mortgage setting (i.e., promissory note, mortgage deed, collateral assignment of leases and rents, security agreement). The construction loan agreement is the most important of these.
The loan agreement will specify the conditions that must be met before the lender advances the necessary construction cash in phases throughout the project. Prior to the initial release of cash, certain requirements must be completed, such as proof of local permissions, such as a building permit, and lender approvals of designs and specifications, a construction budget, timetable, and contractor. Many of these requirements will have been met before the closing.
Over the course of the construction period, there will be further conditions on progress. The lender’s efforts to devise and enforce safeguards against risks inherent in construction loans, such as increased construction costs, weather delays, and unscrupulous or substandard contractors, are part of a larger effort by the lender to devise and enforce safeguards against risks inherent in construction loans. For example, before granting any advance, the lender will usually request inspections of all existing construction work by either the loan officer or another of the lender’s personnel. The construction loan agreement will also specify the frequency of advances (i.e., no more than monthly) and the proportion of the finished work that the lender will advance. As a result, it’s critical that the criteria for advances align with the equivalent clauses in your general contractor’s contract.
Your attorney will provide a mortgagee title insurance policy to your lender at the closing, at your expense, assuring that the lender has first priority lien position in the mortgaged property. Your lender will want to know that it is still in first position and that no contractors or anyone have placed liens on the property since the initial title policy was issued with each advance request. As a result, your lender will almost certainly ask you to submit waivers or subordination of lien instruments covering all work on the project up to the date of the advance. The lender may additionally demand interim title policy endorsements from your attorney to ensure the lender’s priority position at the time of each advance.
The lender will want a certificate of completion from the architect, a copy of the certificate of occupancy issued by the local building official, and an “as built” survey showing the constructed improvements on the land before final payment of the loan proceeds.
The value of the collateral given as security in a construction loan is determined by both the successful completion of the construction and the realisation of the expected economic worth of the completed project from the lender’s perspective. The lender is attempting to protect itself from difficulties that may arise during construction, such as unsatisfactory work, delays in construction, violations of building codes, failure to properly administer subcontracts, and diversion of funds for other purposes, through the structure and administration of its advance programme. While the lender’s advance conditions are appropriate in light of the risks incurred, they nevertheless impose additional costs on you, the borrower. The construction finance process, however, may be extremely manageable and contribute to the successful completion of your project if you take an organised approach with the help of qualified specialists such as your loan officer, attorney, contractor, and architect.