SUMMARY: Find out how construction loans work and what you need to secure one for your business.
Not to be confused with a construction equipment loan or a standard business loan, a commercial construction loan is a specific type of loan designed to meet the needs of construction companies, builders, and developers. Throughout the course of a new construction project, large-scale renovation, land development, or commercial real estate project, construction companies need hard money to operate, so they can pay subcontractors, buy materials, and more.
How Does a Commercial Construction Loan Work?
Once secured, a commercial construction loan is used to cover upfront and ongoing costs associated with a project. Most commercial construction financing operates under what's called a "draw schedule," which means loan funds are released as certain milestones are reached. As milestones are completed, such as running all the electric or framing a building in, the next batch of funds is released.
Most lenders and financial institutions providing construction loans of this type allow borrowers to only pay interest on the loan throughout the project. Interest rates tend to range from 4% to 12%. Once the project is completed, repayment terms often dictate the entire principal be paid off in a lump sum. At this point in the loan repayment process, some builders and companies will choose to apply for a commercial real estate loan or commercial mortgage to cover the principal of the commercial construction loan. This choice allows for lower-cost monthly payments and may help with cash flow for future projects.
Generally speaking, a commercial construction loan functions like a line of credit or a short-term loan.
Getting a Commercial Construction Loan
To get a commercial construction loan, business owners need to supply what most commercial loans require, such as a solid business plan that includes the desired loan amount and expected uses, financial statements such as bank statements and tax returns, a profit-loss statement for the project, etc. That being said, there are some particulars unique to a construction loan. These include:
- Down payment. While many loans require a down payment, there's almost no way to get a commercial construction loan without one. Most commercial construction project loans require at least 10% of the total project cost and some will require as much as 30%.
- A high personal credit score. To qualify for most loans of this type, a borrower needs a personal credit score in the high 600s to low 700s.
- An acceptable debt service coverage ratio (DSCR). A debt service coverage ratio is an estimate of future rents/income divided by future expenses. Most lenders require a DSCR of 1.25 or better.
- An appraisal. A professional appraisal of the project is usually required to secure a construction loan, whether it is land being developed or the construction of a multi-use office building or a multifamily apartment complex.
- Payment of loan fees. From processing fees and documentation fees to project review fees and guarantee fees, borrowers will need to be able to cover costs associated with getting a loan.
Of course, depending on the loan application, the underwriting process, the type of commercial construction loan your are seeking, etc., you may have other requirements.
Ready to start the commercial construction loan process? Reach out to TDECU today.