Applying for Construction Loans Today
As the economy recovers from the COVID-19 pandemic, real estate investors and developers may need construction loans. Here’s an overview of the financial and nonfinancial information that lenders will consider as they evaluate your loan application.
While lenders secure regular commercial loans with existing cash flow, they secure construction loans with unfinished collateral. The collateral’s value depends on the appraised land value, the project’s completion and its estimated economic viability.
Risk is another important consideration. It’s natural for lenders to seek assurances that a developer will manage construction risk from the project’s start. They also want to ensure that developers have enough money invested in the venture to overcome construction problems and complete the project successfully.
Lenders look for red flags when sizing up a project. For example, is land value based on its purchase price or its current market value? If you list the land value as higher than the purchase price due to improvements, expect lenders to question that claim. A higher value may be justifiable, if the developer assembled several parcels to form the development site, but it won’t be justified for costs incurred while demolishing an existing building.
Traditionally, lenders require developers to have at least 20% equity in the project, which can take the form of free-and-clear land. In some situations, lenders may require higher contributions from developers, along with personal guarantees.
Before approaching lenders, review the following financial metrics to see how your project measures up against others:
Loan-to-value (LTV) ratio. In a tight credit market, the project’s LTV ratio is critical. It’s calculated by dividing the loan amount by an appraiser’s projection of the fair market value of the completed and occupied project. Conventional lenders look for an LTV that isn’t higher than 75% to 80%.
Loan-to-cost (LTC) ratio. The project’s LTC ratio equals the loan amount divided by the total project cost from the time of acquisition to project completion. Because lenders are often wary of preconstruction appraisals, they may look to the LTC in their underwriting evaluation.
Predevelopment project costs include all expenses before construction, such as architectural, engineering, survey, legal and permit work. They can also include land acquisition and demolition costs. Development costs encompass expenses from site preparation through construction, including materials, labor, insurance and taxes.
Debt-service-coverage ratio. This measures a borrower’s ability to use its operating income to repay all its debt obligations. Lenders will calculate it by dividing the borrower’s annual net operating income by its annual debt service.
Loan-to-net-worth ratio. Your loan amount shouldn’t exceed your net worth. Be prepared to explain where preconstruction money was spent and the sources for those funds.
Beyond the numbers
Lenders may require various conditions and provisions in both the construction and loan documentation to ensure the project is constructed well, within budget and on time. This includes contract time provisions, use of the property, detailed costs, and caps on change orders and cost overruns.
For larger projects, some lenders will require periodic site visits by an independent engineer, an accounting professional or both. These visits help ensure that the project is progressing as planned and the percentage of costs incurred jibes with the project’s percentage of completion.
In addition, lenders will seek provisions for dispute resolutions and bonding for contractors. Finally, lenders look for assignable contracts to facilitate completion of the work in case of default.
Seek professional guidance
During the application process, lenders will make a thorough review of your financial situation, scrutinizing your prior actions in the relevant market. If you’ve dealt with the financial institution in the past, they’ll also consider your track record with them. To facilitate the application process and put your best foot forward, consult with your legal advisors and CPA to review all paperwork that you’ll present to the lender.