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It’s Just a Construction Loan. What Could Possibly Go Wrong?
If you’re laughing while you’re reading that title, “It’s just a construction loan. What Possible Construction Loan Mistakes Can I Make?” then you’ve obviously done this before. If you genuinely want to know, then please allow me to unpack just a few mistakes in construction loans I’ve seen and regularly see go sideways in development and construction loans.
Construction loans are mortgages with a shorter term and a higher interest rate than pay the expense of building or renovating a home. A construction loan is paid in installments to the contractor, not the borrower, as building milestones are met. Home construction loans are either converted to permanent mortgages or paid off once the construction is completed. You’ll pay a lower interest rate and have a longer repayment time if you finance large improvements with a construction loan rather than a personal loan or a home equity line of credit.
When you start your vision of building a new property, you witness purchasers, as well as lenders and developers, are on the scene with appealing offers. Sure, you can hold your housewarming on a lucky day, but make sure you avoid construction loan mistakes that most people make when applying for a mortgage.
What are Construction Loans?
A commercial construction loan is a form of loan that is used to pay for the expenditures of building or renovating a commercial structure. A construction loan can be used to pay for labor and materials for a new property, the purchase and development of land for a new commercial property, or renovations of existing facilities.
Why Take Out A Commercial Construction Loan?
A commercial mortgage can be obtained by business owners who wish to purchase existing commercial buildings. You’ll need to apply for a business construction loan if you want to renovate your current space or create a new facility from the ground up.
Renovations and new construction can be costly, costing hundreds of thousands or even millions of dollars. Because most developing firms do not have this kind of capital on hand, they must rely on a commercial construction loan. Lenders provide funding throughout the construction process to pay for labor, supplies, and site development so you don’t have to cover the costs yourself using commercial construction loans.
Top Construction Loan Mistakes to Avoid
1. Your deal, pardon my candor, stinks.
The deals look different from my side. For one, I get to see about a thousand deals a year, so I have a very deep library for comparison. Almost every developer or builder comes to me starry-eyed. Convinced that their deal or project is the greatest real estate investment opportunity which ever existed. How many of them can be right? That’s rhetorical, don’t answer. Sadly, all too often, I can tell right away that the deal as they have it imagined, isn’t as great of an idea as they hold it to be.
For example, recently I was approached to rescue finance a sports arena and hotel project which was up for foreclosure sale within the next 30 days. I found an article in a local news outlet from 9 months earlier, where the developer was talking about how great the project was, and how they just needed financing to complete it. The broker who introduced the deal to me was in Pennsylvania, and I’m in Colorado. The deal is west of me. So in 9 months the deal has been seen by dozens of lenders, made it many states across the country looking for one, and is less than 30 days from foreclosure sale. But this developer still believes he has a gold mine on his hands. A gold mine that no one else believes in or wants to fund. Maybe he’s being a tad overly optimistic? Far be it from me to be the killer of dreams. The world needs optimistic entrepreneurs to make things happen. Sometimes, though, those optimists are wrong, and it’s a very expensive learning experience.
2. The powers that be slow the process way down, and you run over your timeline.
Let’s face it, the pandemic slowed everything down. But well before the pandemic, there were municipalities. Some are great, but many are not. They’re either not equipped from a personnel standpoint to handle the capacity of development projects they’re seeing, or they don’t care, or they don’t want it. I see all kinds in all kinds of places. But one thing is for sure, it’s more rare for a city or county office to move quickly, or even at the speed they initially suggested they would or could, than it is for them to take longer, move slower, make unanticipated changes, delay approvals, etc. Many times I’ve seen signed mylars, (think approved site plan), get revised by a government agency, and borrowers sent back to the drawing board with their engineers or architects for months to make minor changes to get that final approval and be able to start construction. All the while, the loan is already in place, interest is accruing, and the maturity date growing closer without any progress on the project. Not the developer’s fault, for sure, but they’re still the one at risk.
3. You underestimate your construction budget or development costs.
Every contractor that wants work tells their customer that they’ll finish on time and on budget. How many do? Well, let’s put it this way, one of the most common modifications we see made to a construction loan is adjusting for budget overruns. It happens a lot. There are many reasons why, one of which I’ll address in the next section, but some include shoddy work by one of the subcontractors, or over-optimism on the part of a builder, or not accounting for weather delays.
4. The market shifts abruptly. (Think pandemic supply chains, as a recent example.)
In the last twelve months we’ve seen material costs skyrocket due to supply chain shortages resulting from the pandemic. Lumber, steel, and concrete shot up in price faster than your granddad’s blood pressure after two scotch whiskey’s and a cigar. If you were mid-construction on a project, but hadn’t yet ordered those materials or locked in your contract price, there was a problem. I saw it affect dozens of builders over a period of several months. Another example was the bubble popping in 2008. How many builders were midway through their development, and blammo! Great project, unforeseeably bad timing. But it happened.
After reading all of that do you feel like scrapping your project? Heck no you don’t! Because you’re a developer or builder, and you’re optimistic and driven to do what you do. So how do you protect yourself from any of these pitfalls on your project or construction loan? Well, truthfully, you can’t. Not all of them. But what you CAN do, is work with a construction lender who works with you to consider these things, and structure your financing in a way to help you best shield yourself from the riskiest risks, and with contingency plans so that you can adjust if or when things don’t quite go the way you planned.
If you’re looking for one such lender, then please reach out to us by CLICKING HERE. We would love to talk with you about a construction loan!