Construction Finance 101
Construction or rehabilitation of real estate for investment purposes can be a complex and timely process involving a number of considerations that need to be managed appropriately to ensure a project is completed on time, within budget, and is ultimately profitable. One critical and difficult aspect of the process if you don’t have the funds needed to complete the project on your own is securing the necessary financing.
There are a number of ways that you can finance the construction of your real estate investment project including through equity, debt, or a combination of the two. Equity will typically come in the form of unsecured financing from investors, but at a significant cost that requires you to give up a share of your profits. Whereas debt is typically provided in the form of a loan secured against your interest in the property, but at a lower cost that pays a stated interest rate pursuant to negotiated terms.
If you are considering a construction loan and believe that you can meet the terms of the loan, there are numerous types of loans available to you. These loans include construction-to-permanent loans, renovation loans, construction-only loans, owner-builder construction loans, and end or permanent loans. While the terms of each of these forms of loan can vary significantly depending on the project and lender, there are some common characteristics that, if understood, should help you evaluate whether and which loan is right for you.
What are Construction Loans?
Unless you have a significant amount of money saved up for a construction project, you’ll almost certainly need to obtain a loan to finance development of the property. And even if you do have the money necessary to finance your development project, a construction loan might still make sense because it provides leverage that allows you to deploy your excess capital toward other projects or investment opportunities.
Very generally, a construction loan is a loan secured by your property that provides you the capital needed to complete all or some of the desired improvements to your property.
Construction loans are often times not offered by traditional banks, and if so on very limited terms, therefore requiring that you work with private lenders who specialize in construction loans. While the terms will certainly vary, typical characteristics of construction loans include shorter terms typically from 12 to 24 months, higher interest rates given the additional risk involved, and the establishment of a construction reserve account that you draw against and only can access upon passing certain benchmarks as construction progresses.
Perhaps one the most notable difference between a construction loan and a traditional real estate or personal loan is in how the loan proceeds are disbursed and paid out. When you obtain a traditional real estate or personal loan a lump-sum payment will typically be made (to you, or the seller of the home or car you are acquiring) when the loan funds. On the other hand, construction loans are more typically funded and paid out by the lender in stages, also known as tranches.
For example, you may secure a construction loan for $500,000, but only a portion of that amount is funded initially, and the remainder is funded and disbursed to you as construction progresses. Because the lender is often lending to you based on the value of the project once it is completed, the lender will only want to disburse the proceeds to you as the project progresses pursuant to the plans and budget. Otherwise, if the lender funds the entire amount of the loan to you upfront and that money does not go into completing the improvements pursuant to the budget, the lender would be left under-secured.
Another key difference with construction loans is the documentation required to secure approval. Because these loans are riskier and depend on certain assumptions, including the future value of the property and that the property will be completed on time and within budget, more documentation is typically required. The lender is likely going to require detailed information about the construction including plans, budgets, city approvals, contracts, etc. The lender is also likely going to require a detailed appraisal that takes all of that into consideration in arriving at a future value of the property. The reason that you need to provide this much documentation is because the underwriting process extends to you, the builder, and the actual project.
Applying for a Construction Loan
If you’re looking to build a new property and want to obtain a construction loan that will allow you to do so, the first step of the process involves filling out and sending in the application for the loan to one or more potential lenders that you have identified. You’ll typically need to provide the lender a certain amount of more limited information about your loan request and the development project, so that the lender can provide you an initial letter of interest with proposed terms.
If you decide to proceed further, the lender will then request more detailed information and further documentation about your loan request and the project to further underwrite the loan. Once the lender has all of the information that they need to evaluate your loan and proceed, your loan will be been approved and ultimately funded, and you’ll be able to begin construction of your development project.
It is important to understand that the loan funds are intended to cover the budgeted cost of labor and materials for the property. You want to make sure that your loan budget is accurate, includes an adequate amount to account for unexpected contingencies, and that the loan provides you sufficient funds to complete the project.
For example, if your construction budget is $500,000, including appropriate contingencies, you will likely need a construction loan of more than $500,000 to account for the escrow, title and lender fees that are typically paid from the loan amount. Therefore, it is important to understand the “net” amount that you are to receive for construction from the loan. If you don’t adequately fund your project, you face the risk of running out of money before it is done, and potentially having the lender foreclose.
Types of Construction Loans
There are generally five primary types of construction loans, though the terms of each may vary significantly by lender. The five types are construction-to-permanent loans, construction-only loans, renovation loans, owner-builder construction loans, and end loans. Different loans are necessary for different types of projects, which is why it’s important that you know what each loan does and what it should be used for.
1. Construction-to-Permanent Loan
A construction-to-permanent loan is likely the best loan available to you if you want to live in the property once built. It provides all of the funds that you will need to develop the home and then live in it with a more traditional mortgage. The money that you borrow will first be used for the construction of your home. Once the property has been developed and you’re ready to move in, this loan will be converted directly into a permanent mortgage, which means that you don’t need to obtain two separate loans.
The closing process on the loan occurs only once, which allows you to keep your costs down. When the loan is converted into a permanent mortgage, it can come with a term of 15-30 years. While a construction-to-permanent loan may save you in closing costs and provide you more certainty, the interest may also be higher because of the increased risk and uncertainty. It also limits your ability to explore the market for the most competitive permanent loan once construction is complete. If you are considering this type of loan, you should carefully weigh the costs and benefits against other alternatives before proceeding.
2. Construction-Only Loan
A construction-only loan just provides you with the funds that you need to construct a property. However, these funds will typically need to be paid back once the property has actually been built, which means that you can’t convert the loan into a permanent mortgage. This type of loan is most commonly used by professional real estate developers who intend to sell the property once it is complete.
Interest rates for these types of loan are typically higher than traditional mortgage loans because of all of the additional risk. Some lenders have set rates depending on various criteria, other lenders will analyze each loan request individually and negotiate an appropriate rate, and others will base their rate on the prime rate set by the Federal Reserve as well as an additional margin. Regardless of how lenders determine their rates, you can expect an annual interest rate typically ranging from 9% to 12% depending on the lender and the specifics of the loan request. The stronger you are as a sponsor, the lower leverage that you seek, and the better the location and quality of the project are all factors likely to help you secure a lower rate.
While these loans are beneficial when you’re developing a project for a profit, building the home of your dreams or moving your business into a new property, they usually cost more than construction-to-permanent loans since you will need to pay two sets of closing costs. It’s also important to note that a worsened financial situation while the home is being developed may cause you to have issues when you try to apply for a permanent mortgage. The term of this type loan is typically 12 to 18 months, though that can also vary depending on the scope of the project.
3. Renovation/Rehab Loan
A renovation or rehab loan is a type of construction loan that provides you the money that you need to remodel or renovate a property and does not involve ground-up construction. It could provide money to a professional real estate developer who is buying a property to do a light rehab and then sell it, or to a homeowner simply seeking to remodel a kitchen. Options for this type of financing can include a government-backed home renovation loan, a home equity line of credit (HELOC), a cash-out refinance where you refinance the property with a new loan and receive cash for a certain amount of the existing equity, or a loan from a private lender that that is treated much like a construction loan but without as many of the requirements.
Because of the many varying options, the cost and requirements for each of these options will also vary significantly. You should assess and compare all potential options before making a decision.
4. Owner-Builder Construction Loans
An owner-builder construction loan is a type of construction loan where you will act as both the borrower of the loan as well as the home builder. These loans are rarely every issued because of how complicated it is to develop a home and the conflicts of interest inherent when the borrower is also the builder. However, you can consider this option if you’re a licensed builder. These are short-term loans, much like a standard construction loan, that will last until you complete construction of the building, which means that the loan terms will likely be 12 to 18 months.
5. End Loans
An end loan is essentially the long-term mortgage loan that you obtain after you’ve developed your home to pay off your construction loan. Whereas construction financing typically bears a higher interest rate and is short term by nature, end loans typically bear a lower interest rate and are long term by nature. They are also referred to as permanent loans. These types of loans aren’t typically available until construction is fully complete and you have a certificate of occupancy for the property. However, if you know that you will need an end loan once construction is complete, you should start exploring your options and speaking to potential lenders well before construction is done so that you can secure the end loan as soon as possible once construction is complete. Loan terms will typically be 15 or 30 years.
Choosing the Best Construction Loan for Your Project
If you’ve made the decision to apply for a construction loan for the development of a property, you need to select the best loan for your project. To do so, you first need to find a lender that offers these types of loans, and evaluate that lender to make sure they are reputable and their terms are competitive. Many lenders don’t offer construction loan financing, which means that you likely need to do some research.
Since construction loans are relatively complicated, you should consider working with a lender that specializes in this type of loan. During your search, it is highly recommended that you obtain multiple quotes from different lenders to determine which lender offers the best terms, down payment requirements, and rates.
AB Capital offers construction and rehab loans to professional real estate developers who do not intend to occupy the home. If you’re interested in such a loan, we encourage you to contact AB Capital today to get more information about AB Capital and its loan programs.
*Disclaimer: The statements and opinions expressed in this article are solely those of AB Capital. AB Capital makes no representations, warranties or guaranties as to the accuracy or completeness of any information contained in this article. AB Capital is licensed by the Financial Division of the California Department of Business Oversight as a California finance lender and broker (DBO Lic. No. 60DBO-69427). AB Capital makes money from providing bridge loans. Nothing stated in this article should be interpreted, construed or used as legal, financial, investment or tax planning advice, or a substitute for thorough due diligence and the exercise of sound independent judgment. If you are considering obtaining a bridge loan, it is recommended that you consult with persons that you trust including but not limited to real estate brokers, attorneys, accountants or financial advisors.