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What are the Types of Construction Loans?
The Urban Land Institute’s (ULI’s) three-year economic forecast indicates that the U.S. commercial real estate market can expect continued growth through 2019. This outlook means construction lenders and construction loan administrators will be busy into the foreseeable future.
There are a variety of construction loan types on the market today. This post is focused on a few of the most common commercial construction loans. These construction loans are used to build projects like The Domain in Austin, Texas. It’s a high-density office, retail, and residential center currently owned by the Simon Property Group. Or, to build a 25-acre family water park in Oahu, Hawaii. Also, the tallest residential high rise tower in the Western Hemisphere was built using construction financing. It is located at 432 W. Park Avenue in New York City. The penthouse unit has 8000+ square feet, 6 bedrooms, and 6 bathrooms with a listing price of $82,000,000.
Let’s take a look at how these and many other developments are financed as well as some of the requirements for a construction loan.
Land Development Loans
Land development financing is generally packaged as either a secured purchase loan or as a development loan.
When it comes to the requirements for a secured purchase loan, borrowers often pledge some asset as collateral. The asset serves as protection in case the borrower fails to pay back the loan. Secured purchase loans typically have lower interest rates compared to unsecured loans.
A development loan involves the purchase of land and lot development for further construction or sale. The land development loan funds the procurement of raw land as well as the making, installing, and construction of land improvements that will convert the site into a construction-ready real estate area. This loan can cover a variety of land preparation projects, such as the installation of a power line, water supply, and plumbing, as well as a sewer connection to the main grid.
If the land is already developed, or is ready to be developed, but requires infrastructure improvements, then the borrower can apply for an acquisition and development loan – A&D for short. This loan will typically cover the cost of the land as well as any improvements before the development stage. Land development loans are repaid based on the sales or development program.
Commercial Real Estate (CRE) Construction Loans
Commercial Real Estate Construction Loans are typically secured by a first mortgage or deed of trust and backed by a purchase or takeout agreement from a permanent lender. Most U.S. states use a first mortgage to secure these loans, but about 20 states use a deed of trust, which is a legal title in the property that is transferred to a trustee. The trustee then holds the deed as security for the loan between a borrower and lender. A takeout agreement is a written certification that the lender will provide permanent long-term financing at a point when the project reaches a specified stage.
The disbursements of CRE construction loan funds occur as the project progresses and within a specified period, which serves as a way to closely monitor the project to avoid risk. The funds are disbursed based upon either a standard payment plan or a progress payment plan. The standard method, used for residential and smaller commercial construction projects, requires payments to be disbursed based on a schedule aligned with specified stages of construction.
“Our number one goal is to get repaid because the project was completed on time and on budget. Then we can lock in interest income and earned fees.”
VP, Commercial Real Estate, Top 35 Largest Bank in the U.S.
Larger building projects generally make monthly progress payments totaling up to 90 percent of the value. This type of progress payment plan then holds back 10 percent of the total loan amount as final payment. This holdback is called Retainage, and it is deliberately withheld to ensure that the contractor completes the construction project.
In our Kickstart Guide to Construction Loan Administration, we share the ins and outs of managing the loan disbursement process which involves a draw request package loaded with documents like invoices, receipts, and liens.
Residential Construction Loans
According to the NAHB, community banks account for nearly 50 percent of all residential construction loans on the market. Moreover, the combined total of individual residential construction loans may represent a large part of a fund portfolio for banks with assets between $100 million and $1 billion. In contrast, banks with between $1 billion and $10 billion in assets hold a much lower percent of residential construction loans relative to their non-residential construction and land loans.
Residential construction loans are made either on a speculative basis (Spec Loans) or as prearranged permanent financing. It’s a best practice for loans on larger residential construction projects to have permanent funding in place, as it can affect sales of finished homes. Banks typically set a predetermined limit on the number of unsold units to be financed at any one time. This policy reduces the risk of contractors overextending their capacity.
However, a speculative home construction loan helps single-family home builders that don’t have secured sales. These loans offer flexible options like using the land equity as a down payment, flexible draw schedules, and interest-only payments during construction on the funds drawn.
Residential tract development loans finance the development of five or more units. Examples include a residential building lot, a detached single-family home, an attached single-family home, or a residence in an apartment house. The lending institution needs to obtain an appraisal that includes the entire tract of land, the projected market value upon completion, as well as the current value of the property.
What is a Construction to Permanent Loan?
Simply put, the construction-to-permanent loan means that the lender will convert a construction loan into a permanent mortgage after completion of the construction project. The borrower can choose a fixed-rate loan or an adjustable-rate loan, further specifying loan terms and conditions.
In the second quarter of 2018, construction to permanent loan rates range roughly between 4 percent on the low end to 15 percent on the high end.
As you can see, construction loans come in all shapes and sizes. Construction loans also tend to carry a higher risk than other types of loans due to market forces and a variety of things, like a mechanic’s lien for example, which often delay the completion of projects.
The top risk associated with construction lending is anything that prevents completing the project. To mitigate the risks associated with real estate construction loans, the FDIC suggests lenders define procedures for controlling the disbursement of funds and the amount of loan versus the assets used as collateral on that loan (collateral margins) to ensure completion of projects and payback of the investment.
Here are three ways to help mitigate risks associated with construction lending, to control the disbursement of funds, and to monitor collateral margins: