How Do Commercial Construction Loans Work?
April 21, 2014
Commercial construction loans are a complicated process. But once you understand how they work and start thinking like a commercial construction loan lender, you will know what it takes to obtain one. At Apartment Loan Store, a commercial mortgage banking firm, we work backward and start with prequalifying the permanent loan. We recognize that commercial construction loans have seven key components that will need to be analyzed by the lender to pre-approve the loan. Here they are:
- Start With the Income of the Property – This is because the size of your construction loan will ultimately be constrained by the size of your permanent loan – what the net operating income of the property can cash flow to obtain a permanent loan. Once you know the square footage of the building or the number of units, do a pro forma rent roll and estimate the gross rental income of the property based on currrent market rents. Next estimate expenses, including real estate taxes, insurance, maintenance, management, etc. Next complete a pro forma (projected) annual income and expense statement and come up with the estimated annual net operating income (income minus expenses). Now figure what the debt coverage ratio will be for the permanent loan. Divide the annual net operating income into the annual loan payments and multiply this number by 100: NOI / ADS = ( ) X 100 = DCR. This ratio should be at least 1.25 for multifamily and 1.35 for a multi-tenant property. All commercial loans are restrained by a debt coverage ratio.
- Estimate the Appraised Value – This is because the size of your permanent loan will also be constrained by the appraisal. Get a commercial realtor to look at sales comparables for this type of commercial property and get a realistic estimate of what the property will appraise at when completed and stabilized (leased at market occupancy). Most construction loans are maxed at 75% of the appraised value.
- Estimate the Cost of Construction – Start with the cost of the land. Then
Include all major hard costs: the cost of excavation, foundation, framing, drywall, roofing, electrical, plumbing, pavements, HVAC, services, interior work, etc. Then include all soft costs: plans and specs, permits, legal, taxes, insurance, and loan fees. Then add on a 5% contingency (cost-overrun fund). It’s best to get an estimate from your general contractor.
- Estimate the Size of Your Construction Loan – Most construction loans are maxed at 75% of cost. Some do go to 83.3% of cost. Make sure that your maximum construction loan is not larger than what can be supported by the property’s net operating income and the appraised value.
- Determine If You Have the Financial Strength and Credit – You will need good credit (a score of 680 or above). You can always qualify for a hard money loan if your credit is not great (if the project can afford it). You will also need to have a net worth at least the size of the loan you want to obtain and have the down payment, closing costs, plus 15% to 20% in post-closing liquidity. If your personal financial statement doesn’t support this, then perhaps you can bring on a partner with additional financial strength.
- Determine If You Have the Experience – Lenders today want to make commercial construction loans to experienced developers that have a track record of completing and renting out their new development projects. If you don’t have prior experience, you might need to bring on a partner who does.
- Determine If Your Contractor Will Qualify – Lenders will require you to have a licensed bonded contractor with a resume showing they have completed similar construction projects. The lender will want to check the contractor’s credit and references. On larger projects, the contractor might need to be financially strong enough to qualify for a performance bond.
At Apartment Loan Store and Business Loan Store we have specialized in commercial construction lending since 1997. We would be pleased to assist you in prequalifying for a commercial construction loan up to 83.3% of cost.Source: apartmentloanstore.com