A Look At Construction Loans
The most common form of borrowing for commercial real estate transactions is the first-lien commercial mortgage loan. With principal running anywhere from $300,000 to many hundreds of millions, the financing of most (but nowhere near all) industrial, office, retail and multifamily property tends toward this form of debt, which is commonly priced somewhere between 75 and 150 basis points above 10 year US Treasuries.
Naturally, it’s often a combination of debt and equity that finances a commercial property transaction. And equity isn’t always the simple “down payment” residential brokers are familiar with. Far from it: commercial property financing options abound to add to the first-lien loan, including mezzanine loans to bring the loan to value (LTV) up even as high as 100%. Other strategies include A-note an B-note division of debt, or even “preferred equity” where a third party secures a loan with equity in the property that has an edge on other lenders in the competition for cash flow off the property in the event of default.
But commercial real estate is a complex beast, not limited to a market in tangibles. The role of CRE in economic development is critical, which means future propositions – new construction – needs financing just as much if not more than ownership transactions do. What do properties that sport no cash flow (because they don’t exist yet) have to bring to the table to get the financing they need?
The most common forms of financing for these are the construction loan. Secured by properties that are under construction, with no cash flow, these loans are considered higher risk that first lien, which makes sense when you consider the construction lender’s prospects include a lien on nothing more than a hole in the ground and a pile of unassembled building elements . More often than not, the borrower(s) set up a reserve account at the origination time of the loan in order to pay the interest on the principal. Loans tend to mature in 12 to 36 months and principal reflects the construction’s budget plus a modest contingency. The loan’s repayment is contingent on completion of construction, that magic time when the intangible becomes tangible and permanent financing can be established.
The distinct and unique risks of construction finance also call for the provision of the principal in stages associated with construction progress. As with so many subsections of commercial real estate, expertise is earned with focus and professional development that comes with experience. Examining the shapes and sizes of construction finance is instructive from both the lender and borrower sides. One of my favorite sources on the topic is the Associated General Contractors of America’s Guide To Construction Financing, a concise review of common practices across all 50 states.