Obtaining a construction loan is not easy. Improve your chances of acquiring construction financing by assembling an experienced development team which includes: a real estate broker, an architect, an engineer, a general contractor, and a mortgage broker.
The presentation and the audience of the loan request are critical to expedite the process of obtaining construction financing.
Five tips to expedite the construction loan request and get your loan funded:
1. Pursue the Right Lenders
Avoid wasting time searching for the wrong construction lender. First, know whether your loan is best suited for a conventional or private money lender. A typical conventional lender is a bank or credit union which are heavily regulated but provide the cheapest form of debt. A private money lender is a private mortgage fund or group of individual investors which have more flexibility but at a higher cost.
The type of lender category you pursue will depend on several factors including: timing, loan type, property type to be built, preleased or spec space, owner/builder and the creditworthiness of the borrower.
For example, if a borrower had filed for bankruptcy in the recent past, the loan will most likely be funded by a private money lender. If a borrower is developing an office building, preleased to a credit tenant, a bank would be the likely construction lender.
Once you determine the lender category, whether conventional or private money, determine which lenders specialize in construction loans in your submarket.
Often local construction lenders are the best choice. A local lender knows the submarket and relies less on third-party consultants to interpret the market. A local lender will typically be faster at processing and closing the loan.
2. Present Loan Request in an Executive Summary Format
Identify the potential lenders that may be interested in your loan request, document the request in a brief executive loan summary (no more than 2 pages).
In the executive summary only include salient facts and no additional details. Do not overwhelm the construction lender with additional documentation on the initial request. Make it as easy as possible for the lender to decide if your loan is one to pursue.
A loan summary that is concise and easy to understand will move your deal to the top of a lender’s loan request list. This applies to both conventional and private money lenders.
See link for an example of an executive loan summary template to use when making your initial pitch to a lender for a loan request.
Once the construction lender has expressed interest, additional detailed information in the form of a loan package will need to be provided, including; developer and general contractor resume, detailed cost breakdown, plans, financial statements, bank statements, tax returns, borrowing entity information, purchase agreement, preliminary title report, photos, etc.
See link to “helpful hints” on what to include in your construction loan package once the lender has expressed an interest in pursuing your loan.
If a lender decides to move forward, they will usually issue a letter of interest or an application documenting the loan terms and the third party reports required to proceed in obtaining final loan approval.
3. Address Mitigating Lender Construction Risk
A construction loan poses more risk to a lender than a normal real estate loan therefore, as a borrower, you must demonstrate how you are mitigating the construction risks to improve your chance of getting a construction loan funded.
The major risks to a construction lender are getting the project built on budget and the loan paid off. These risks include an inflated budget with the risk of overfunding the project in comparison with the value, or a budget that is insufficient to complete the project, thus requiring additional equity or loan advances.
It’s key to show the construction lender you have an experienced team of people that have done the following:
- Secured the right property location
- Produced properly designed plans
- Generated an accurate budget
- Navigated the political approval process
- Obtained the entitlements to construct the improvements
- Projecting an acceptable exit strategy
A key factor to mitigating construction risk is hiring an experienced general contractor (GC) who has constructed similar type projects on budget. Scrutinize the general contractor’s prior history with other fund controls and lenders. Ensure the GC’s license is in good standing along with knowledge of previous or pending litigation.
Projects rarely come in on budget. Include a healthy contingency line item in the budget to give comfort to the lender that there will be sufficient funds available to complete the project. A minimum of 10% of the hard costs is typically acceptable for an ordinary real estate project that is not special purpose or in a compromised location requiring additional precautions.
To help ensure the construction lender market risk is mitigated you need to show a strong product-market fit. The market risk of demand changing in the future needs to be addressed with a proper market study or an appraisal with statistics supporting the product type and its present and future feasibility.
4. Show Adequate Sponsorship
For a construction loan to get financed, the borrower needs an acceptable net worth, liquidity, and respectable credit. The borrower financial requirements will vary among lenders depending on the project size, type, and complexity of construction.
The quality of your credit history will determine whether you will qualify for conventional or private lender financing. Expect full recourse (personal guarantees) for almost all construction loans. As an alternative, some private lenders will accept a completion guarantee.
5. Present a Viable Exit Strategy
It’s important that the lender trusts your exit strategy because this is how they will get paid back.
The exit strategy will determine the type of construction loan you need and the amount of leverage a lender is willing to provide.
If it is a “for sale project,” e.g., a residential condo project, it will be an interest-only construction loan with no conversion option. However, if it is a “for lease project” for investment, it may need an interest-only construction loan that converts to a mini-perm or an amortized long-term permanent loan.
A “for sale” exit strategy relies on a product market fit; including a viable sales value comparison approach and market demand for the specific product type.
A real estate project, held as an investment, with a “refinance” exit strategy, requires the construction lender to focus on how the takeout lender will underwrite the permanent loan. For example, what is the debt service coverage ratio being used by the permanent lender? What’s the anticipated interest rate at the time of the permanent loan? What’s the amortization schedule? These factors affect the construction lender’s determination of the maximum loan amount and the probability of a successful takeout loan.
Remember, brevity and clarity is needed to assemble the best construction loan request along with key business relationships to target the right lender and expedite the funding of your construction loan.