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A Comprehensive Guide on How Commercial Construction Loans Work

So you’re a real estate developer, investor, or builder, and you’re looking for funding for your next project? It can be difficult to know where to start, when you’re typically talking about dollar amounts in the tens of millions. Whether it’s a land acquisition, finishing lots for a single family home subdivision, a townhome development project, a multi-family or mixed use apartment construction project, or office, retail, industrial, self-storage, or other commercial property construction loan – we want to help you comprehend the entire picture of How Commercial Construction Loans work at The Construction Lender.

What is a Commercial Construction Loan?

How commercial construction loans work

A commercial construction loan is used to pay for the development, construction, or renovation of real estate investment property. The cost of these types of projects might range from tens of thousands to millions of dollars. In most circumstances, real estate developers, investors, and builders are unable to bear these expenses on their own. This loan can be used to cover a variety of expenses, such as construction supplies, labor costs, site acquisition, and development, or renovations, value-add, or rehab for an existing property. A commercial mortgage may also be an alternative for business owners considering purchasing existing commercial property. However, if you want to renovate an existing space or start from scratch, you should apply for commercial construction financing.

The borrower and the lender work together to develop a draw schedule for commercial construction loans. This means that as the project proceeds and reaches various milestones, partial amounts of the loan are disbursed. For example, the first pull of funds could be used to develop land, while the second draw would be used to pour concrete and frame the structure. This process continues until all of the milestones have been met. Keep in mind that before making another draw, lenders usually require an inspector to check that each step of the work is completed.

You typically only have to pay interest on the funds of the loan that have been received with commercial construction loans. For example, if a new building costs $500,000 but your lender only gives you $100,000, you will only be responsible for paying interest on the $100,000. The borrower typically pays only the interest on drawn funds on a commercial construction loan. Although sometimes commercial lenders have minimum interest requirements. The borrower can then pay off the principle in one big sum at the end of the project when they sell it or refinance it out into permanent debt.

How Commercial Construction Loans Work?

Construction loans are distinct from other types of financing. The majority of loans are structured so that the borrower receives the entire loan amount in one single sum. After receiving the loan, the borrower begins making scheduled payments over a defined period of time to repay the loan. Commercial mortgages, for example, sometimes have a ten-year or longer payback schedule.

The entire loan amount is not obtained upfront with commercial construction financing. Instead, the borrower and the lender will work together to develop a draw schedule. This means that as the project progresses, portions of the loan will be released in stages. The first draw, for example, will be for land clearing and construction. When the foundation is poured, the next pull may occur. When the structure has been framed, another draw will be made, and so on.

A lender will normally demand an inspector to check that the work is complete before issuing the next draw once each milestone is achieved. This process will continue until all milestones have been met and the entire loan amount or funds have been dispersed. You typically will only pay interest on the percentage of the loan funds that you have received with a commercial construction loan, unless the lender requires a minimum interest amount. For example, you will pay interest on $100,000 if the total cost of your new construction is $500,000 and the lender has only issued $100,000.

A commercial construction loan is often arranged so that the borrower only pays interest until the loan is fully disbursed. At the end of the construction project, borrowers can pay off the principle in one single sum.

But, once the project is completed and the loan balance is due, what should a borrower do next? The borrower can now get a commercial mortgage or permanent loan refinance instead of making one huge payment. The property will be used as security, and the proceeds from the commercial mortgage will be used to repay the commercial construction loan. The borrower will be locked into more affordable monthly payments over a longer period of time with the new mortgage.

Other commercial construction loans, such as the Small Business Administration CDC/504 loan, offer more long-term possibilities, eliminating the need for a second loan after the project is completed.

Interest Rates

Borrowers can expect to pay interest rates ranging from 4% to 12% on commercial construction loans. Borrowers with the finest credit ratings and strongest balance sheets will be offered the most favorable interest rates. The sort of lender you use is also a consideration. A commercial construction loan from a bank would usually have the lowest interest rate, however, loans from hard money lenders will have higher interest rates.

What are commercial construction loan requirements?

Each lender will have its own set of qualifying standards, but if you’re a small business, personal credit scores are a crucial element of the process. While a score in the upper 600s is normally preferred, some private lenders will consider borrowers with lower credit scores, or negative past credit history. Of course, better credit usually means better rates.

The financial health of your company, in addition to your personal credit score, will also be considered. Your company credit score, as well as your debt-to-income ratio, will be considered by the lender. Simply explained, this is the difference between the amount of money coming in each month and the amount going toward debt.

Why Take Out a Commercial Construction Loan?

Business owners who want to buy an existing commercial property can qualify for a commercial mortgage loan. A commercial construction loan, on the other hand, is the way to go if you want to renovate an existing structure or even create one from the ground up.

Commercial construction loans are distinct from other types of financing available. Other loans provide the borrower a lump sum payment and require the borrower to repay the money over a set period of time. The entire loan amount is not given to the borrower upfront with commercial construction loans. Rather, the borrower must collaborate with the lender to develop a draw timetable. In other words, as the borrower progresses through the project, they will be able to “unlock” fresh amounts from the loan.

What is the commercial construction loan process?

What is the commercial construction loan process?

While the process of obtaining a commercial construction loan may appear onerous, it is actually rather simple. Here’s a rundown of what to expect from beginning to end.

1. Choose a Lender & Submit Application

It’s time to start your application once you’ve decided on the types of commercial loans you want (as well as the individual lender). You’ll have to supply a lot of information about your personal and business finances, including bank accounts and tax forms, among other things.

In addition, you’ll need to gather information regarding your construction job. This should include specifications, preliminary designs, cost estimates, and other information. Another usual necessity is a complete business plan that explains your existing operations and future expectations.

2. Review &  Approval

Your application will be reviewed several weeks after you submit it. You’ll most likely need to give extra information or papers during this period. The sooner you can gather these items, the better. This will expedite the process and allow underwriting to begin. It’s time to close when your loan agreement has been authorized.

3. Closing

A comprehensive examination of the loan agreement, as well as signing, is normally part of the closing procedure. Construction can begin after this is completed.

Eligibility for a commercial construction loan

Your credit score and debt-to-income ratio are the two most crucial factors in commercial building loans. Lenders typically aim for a debt-to-income ratio of 43 percent or less, however, some may have tougher criteria. The lower your DTI, the more likely you are to get approved. Keep in mind that hard or private money loans are usually manually underwritten, so special situations and circumstances, as well as all financial information will be individually reviewed, and not automated.

Is A Down Payment Required For Commercial Construction Loans?

Construction loans for commercial buildings are considered high-risk loans. As a result, a down payment is necessary. The typical down payment ranges from 10% to 30% of the overall planned price. Please keep in mind that a lender will rarely pay the entire cost of a commercial building project. Lenders typically use a loan-to-cost calculator to calculate the down payment. The Construction Lender prides itself on offering higher loan to cost terms, requiring less cash in the deal, or lower downpayments. Each deal is unique, so a preliminary review can quickly determine how much cash will be required for your particular construction or development loan.

Purposes of Commercial Construction Loans

Borrowers can use commercial construction loans to create new commercial properties. Existing commercial properties can also be reconstructed, rehabilitated, or upgraded. They are as follows:

  • Loans for Multifamily or Apartment Housing
  • Loans for Office or Retail Buildings
  • Hotel Investing
  • Hospital Construction Loans
  • Loans for Mixed-Use Development and Construction
  • Loans for Industrial Parks
  • Loans for Master-Planned Communities or Single Family Home Subdivisions
  • Loans for Townhome Developments
  • Loans for Land Acquisition and Development
  • Bridge Loans to Permanent Financing

Final Thoughts

New construction and remodeling projects are more speculative than purchasing an existing, ready-to-use structure. Many real estate developers, investors, and builders do not have the financial means to invest millions of dollars in property developments. This is where commercial construction loans come in, with lenders offering just enough funding to cover necessary costs such as labor, supplies, and site development during the construction process.

It’s thrilling to get to the point in your business where you’re ready to grow. However, funding these projects can be difficult to come by. If your company wants to build new structures or remodel old ones, a commercial construction loan can make the process easier.

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