Commercial Construction Loans Primer

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We will usually get 1 or 2 projects a day from sponsors or brokers asking whether we can get their construction projects financed.We usually subject the project to a quick quantitative analysis to determine whether we should pursue financing for a project.This allows us to filter based on objective measures rather than subjective feel.I have fallen in love with a number of proposed developments only to find out that they were not economically feasible after running the numbers.I hope this helps both developers and brokers come to realistic conclusions regarding the financing of their projects.It’s not that their projects can’t be financed.It just may take an adjustment to the overall capital stack to get it done.For instance, a mezzanine loan may be needed to fill a portion; or maybe an equity partner can help increase the equity portion of the stack; or, maybe both are needed to complete the financing stack. So here is the quick primer.

Commercial construction loans are usually underwritten using 6 financial ratios. Every lender has its own parameters for each ratio, and each loan will probably not necessarily meet each parameter for a lender. This is where a lender’s judgment comes into play as well as the relationship that the lender has with the borrower or broker.The relationship (if good) can possibly sway the lender to take a chance if the business plan is solid.

The loan-to-cost ratio is the construction loan amount divided by the total cost of the project. This ratio typically should not exceed 80%. In other words, the developer is responsible for contributing at least 20% of the total cost of the project - usually in the form of free-and-clear and entitled land, with most of the architectural and engineering costs prepaid for by the developer. Plan for the lender to quote at 70% to 75% LTC.This means that the developer must cover 25% to 30% of the total cost of the project.

The loan-to-value ratio on a commercial construction loan request is computed by taking the construction loan amount and dividing it by the value of the commercial property, when it is completed and fully-leased. The loan-to-value ratio on a commercial construction loan request should not exceed around 70%.This provides some cushion for the sponsor to refinance the property to pay off the construction loan.

The debt service coverage ratio is the property's Net Operating Income (NOI), upon completion and leasing, divided by the annual debt service (P&I payments) on the proposed takeout loan. A takeout loan is just a permanent loan used to pay off a construction loan. This ratio should exceed 1.25.

The profit ratio is the difference between the fair market value of the property, upon completion and leasing, and the total cost of the project, all divided by the total cost of the project. Measures the potential profit for the developer for building the asset. The developer could be tempted to walk away if the project becomes a headache for him or her without a huge incentive on the back-end. The profit ratio should exceed 20% to 22%.

The net-worth-to-loan-size ratio. The developer's net worth should be at least as large as the construction loan he is requesting. This ratio needs to be at least 1.0.There is no hard and fast rule on this ratio as to whether the loan request will be turned down.The lender (bank or private) will most likely use it to either resize the loan request, or adjust other parameters to reduce its risk.

The debt yield ratiois computed by taking the property's net operating income (NOI) and dividing it by the construction loan amount. 8.5% to 9% is probably the minimum.This is the lender’s expected return if it had to take back the property.

The bottom-line? Run the numbers.

Hey @Rich Coppage , thanks for the post!

Your title says "Landlord" but it's apparent that you have some solid lending/analysis experience.

I'm working my way into more complicated deals... do you happen to have a sample deal that you can share, that takes the points in your post into consideration? A spreadsheet and a fact sheet that demonstrates your points would be amazing.

Great Post! - looking forward to any additional input.

My bank just wants the land paid for and for the project to appraise. They loan 70% of the value of the completed project as a typical construction loan, than after its done it converts to regular mortgage. 

For example the loan I'm doing now:

Finished project value $2,660,000

@ 70% LTV is $1,860,000

I'm putting up the land, this is a very typical structure in my area a lot of rental projects are financed this way.

Originally posted by @Chris Field :

My bank just wants the land paid for and for the project to appraise. They loan 70% of the value of the completed project as a typical construction loan, than after its done it converts to regular mortgage. 

For example the loan I'm doing now:

Finished project value $2,660,000

@ 70% LTV is $1,860,000

I'm putting up the land, this is a very typical structure in my area a lot of rental projects are financed this way.

 Pretty much throughout the country the land meets the equity requirements (at least 20-30%) for a construction loan, and since you've probably already bought the land before closing the loan, they give you credit for it.

Where it gets tricky is in situations where you've owned the land for some time and claim that it is now worth X times the original purchase price.  I find that as long as the appraiser agrees, you get that credit too.

My cynical view is that the lenders give more credit towards the appraisal than they should, but the regulators require them to get one.   

My bank doesn't care what I paid for the land this particular parcel has been in the family since 2007 and has been horse traded around a bit. Most of my family does this, so we trade parcels around once in awhile. They will loan 70% on the land as well, but the value is not their until its approved. As a crappy house its worth $190k, as an approved 15 unit site its worth $600k or so. 

I bought my interest in this piece a couple years ago with a SFH building lot, which I got for almost free. I exchanged about $10k of actual money, and about $30k in approval costs for a 50% ownership position.

@James W.  -

Appreciate the input James but I wouldn't consider myself a landlord.  While I own a couple of properties, it is not what I principally do in real estate.  I'm on the commercial financing end of the business.  Mostly finance ground up commercial developments through debt and equity structures, so I have a little bit of insight into the process.

I'm looking to refinance a commercial loan because my current loan is going to mature on Jan 1st. I owe $300,000 and the value of my property is $1M. So low loan to value. Who is a good commercial lender?

@Rich Coppage , great post. It is exactly what I am looking for.

Has the guideline been tightened by lender in 2018?

We, a group of land-owners, want to connect to commercial construction lender for our project in Northern California.

@Thuy Vo ...Guidelines for the most part on construction have not changed much, but construction lending has been more restrained by regulations.  So there are fewer lenders who are putting out construction monies.  Leverage is going to be somewhat dependent on project and asset type being built.  I'd like to see what you've got going on if you haven't found what you're looking for. PM me.

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