Commercial Construction Loans: Complete Guide

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Commercial construction loans operate similarly to standard construction loans. However, the primary difference is that they are designed for commercial property. This typically means commercial real estate or residential buildings with more than four units. The funding is not paid entirely upfront as typical with conventional mortgages. Instead, the lender pays the loan in scheduled installments over a specified period. The installments are known as draw periods, which are paid out after completing pre-determined milestones. For example, the landmarks may include:

• Developing the raw land
• Laying the foundation
• Creating the building frame
• Installation of HVAC and electrical wiring

After completing a construction milestone, you will receive the next installment. For example, you may receive 25% upfront and the next 25% once the foundation is laid. The future installments will be paid out after accomplishing other pre-decided milestones. An inspector will review the accomplished work before issuing the installment. This method reduces lender risk since construction lending is high risk.

Continue reading for a comprehensive overview of commercial instruction loans. This article explains the structure, available options, requirements, and where to get them.

Interest Rate

The interest rate for commercial construction loans is typically higher than that of traditional types of mortgages. It can vary significantly depending on the lender, loan amount, and other factors. However, rates are still lower than those offered by short-term commercial lenders.

Term Length & Payments

Most commercial construction loans have a term of one year. The term is designed to last the length of the construction period. In most cases, the borrower will need to make interest-only payments. With each draw period, the monthly payment will increase. However, the principal is only due at the end of construction as a balloon payment.

Lenders will charge extension fees for surpassing the one-year term length. At the end of the one-year term, borrowers will refinance the construction loan into a standard commercial mortgage once the building is completed. This is a less risky loan that reduces the interest rate.

Down Payment

Most lenders use a maximum loan-to-value (LTV) ratio. However, since the value is subjective in construction, most lenders use a loan-to-cost (LTC) ratio. This is the percentage of construction costs that are financed by a loan. Most commercial construction lenders have a maximum LTC of 70% to 90%. This means they will finance up to 70% to 90% of construction costs for a down payment of 10% to 30%. Your minimum down payment will depend on your corporate risk profile, which includes your credit score and debt service coverage ratios.

Fees

Aside from interest, there are other fees associated with commercial construction loans. These will vary depending on the lender and the specific terms of the loan. However, typical costs include the following:

• Appraisal fee: This is the cost of determining the estimated value of your property.
• Loan origination fee: This one-time charge covers costs associated with setting up and processing your loan.
• Underwriting fee: The cost of reviewing your loan application and evaluating creditworthiness.
• Document preparation fee: This covers all administrative tasks for processing your loan.
• Time cost: This is the time you spend working on the application and review process. It includes all communication with your lender and any required meetings or site visits.

However, some lenders may offer a no-closing-cost mortgage which rolls costs into your payments. In addition to these upfront fees, ongoing costs are also associated with maintaining a commercial construction loan. These include administrative fees, interest payments, and penalties for missed payments.

Types of Commercial Construction Loans

There are a few different types of commercial construction loans. Each has its own set of terms and conditions, as well as benefits and drawbacks. Understanding the differences is essential before deciding which type is best for your business. Here's a rundown of the most common types of commercial construction loans:

SBA Loans

These loans are backed by the Small Business Administration (SBA). This option is popular because they have the lowest down payment requirements. SBA loans can provide financing for up to 90% of construction costs. They typically have lower interest rates than conventional construction loans but also come with additional requirements for qualification. For example, you'll need a minimum credit score of 600 to 680. There are two standard types of SBA commercial construction loans;

• SBA CDC/504 Loans: This option offers a long-term, fixed rate of up to $5,000,000. In most cases, the term length ranges from 10 to 20 years with a down payment of 10% to 30%. Aside from business collateral, business owners must personally guarantee the loan. Interestingly, only a maximum of 40% of the project's costs will be financed by an SBA-certified lender. As such, the borrower must find a secondary lender. In most cases, the secondary lender will provide another 40% to 50%, leaving a down payment of 10% to 20%.
• SBA (7a) Loans: These are the most popular type of small business loan. However, it also applies to purchasing and constructing real estate. This option provides a slightly more extended repayment period of up to 25 years. Additionally, there is a maximum $5,000,000 lending cap and a requirement for a 10% to 20% down payment.

Construction-Only Loans

The standard type of construction loan is known as construction-only. As the name implies, this loan only covers the construction period. Once the term length has expired, the borrower must repay the loan. This is typically done by selling the property or refinancing it into a commercial loan.

If the borrower pursues refinancing, they'll need to requalify for another mortgage. As a result, there is a risk of not qualifying for the new mortgage. This risks the inability to repay the construction-only loan and subsequent bankruptcy. Many borrowers use a construction-to-permanent loan to mitigate this risk, as discussed below.

Construction-To-Permanent (C2P) Loans

While a construction-only loan requires you to refinance later, a construction-to-permanent loan handles the whole qualification process upfront. Otherwise known as a C2P loan, this option is best for those who want a stress-free guarantee of a smooth transition from construction to a commercial mortgage. It is important to note that a construction-to-permanent loan still has a maximum time limit. Some lenders can grant extensions, but this may come with additional fees.

This type of loan combines a short-term construction loan with a long-term mortgage in one loan, making the process more efficient. The borrower qualifies for everything upfront and has predictable funding throughout construction. Additionally, you will save on multiple sets of closing costs but may have a slightly higher interest rate.

Blanket Loan

A blanket mortgage is a type of construction-to-permanent loan. It allows borrowers to consolidate multiple properties into one loan. For example, a commercial builder developing many properties would use a blanket loan. These loans allow borrowers to consolidate the cost and closing process into one transaction. Another benefit is that blanket loans can help business owners save on legal fees and precious time.

Sometimes, the loan acts as a line of credit that allows the builder to re-borrow after selling one property. For example, imagine a developer is using a blanket loan to build five properties. After selling one property and paying off that portion of the loan, the builder can re-borrow to develop a new building. As a result, blanket loans are very popular with large-scale commercial builders.

Commercial Construction Loan Requirements

In the course of the application, the lender will assess your financial situation as well as your credit score to determine whether your loan is approved or not. Construction loans are deemed highly risky and require a comprehensive building proposal by the lending institution. The application process includes

Corporate Risk Profile

Lenders require applicants to have good credit scores and an adequate debt-service coverage ratio (DSCR). This can include profitability ratios, cash flow projections, tax returns, and bank statements.

Generally, to qualify for an SBA loan like the CDC/504, you'll need a credit score that's in the high 600s. However, individual lenders will have their standards for deciding creditworthiness.

Lenders also want to ensure your business has the profitability to make monthly mortgage payments. This is measured through a debt service coverage ratio (DSCR). While similar to a debt-to-income ratio, DSCR represents how often a company can make loan payments with its net operating income (NOI).

For example, assume the annual NOI is $100,000 with $50,000 debt payments. As a result, the NOI can double the debt payments for a DSCR of 2.00x. Most lenders want to see the ability to make debt payments with a safety margin. As a result, there is typically a minimum DSCR of 1.25x.

Detailed Construction Plan

Your construction plan is a critical component of your application. This needs to include the following:

• Scope of work & materials list
• Project summary & timeline
• Project budget

Proven Industry Experience

To qualify for a construction loan, lenders typically require the builder to have experience in the industry. This can include previous projects and recognized certifications or credentials like an architect license or contractor's license.

Qualified Builder

Additionally, your builder needs to be qualified and experienced in construction. For example, if you are planning a commercial building project, you may want to work with a general contractor with experience working on similar projects.

Where to Find Commercial Construction Loans

Several lenders offer commercial construction loans, including traditional banks and specialized lenders. You should compare different options available to you and pick one that best fits your needs. You can use the commercial mortgage calculator to compare different loan options available.

Banks and Credit Unions

Banks and credit unions may offer construction loans if they have a commercial lending department. These lenders typically require strong credit scores, a solid financial history, and other factors that indicate you are likely to be able to pay back the loan. Credit unions may be more flexible with their qualification criteria.

Online Lenders

Online lenders may be a good option if your business is in its early stages and you have a limited credit history. Online lenders are more likely to consider factors like cash flow, profitability ratios, and other financial metrics that traditional banks may not consider.

Portfolio Lenders

Portfolio lenders have the most flexible lending criteria. This is because they don't resell your mortgage to another investor and keep it. As a result, they may decide to flex lending criteria if they believe you are a good borrower. They may have specific requirements for qualification, such as the size of your business and other factors.

Hard Money Lenders

Hard money lenders offer a variety of construction loan options and may be able to provide financing regardless of your credit profile or financial history. However, they often come with higher interest rates and more onerous terms than other types of commercial construction loans.