- Commercial construction loans are used to purchase, build, or renovate commercial properties.
- A wide variety of lenders offer commercial construction loans, including conventional lenders, hard money lenders and private lenders, and the Small Business Administration.
- Commercial construction loans have a more holistic underwriting process, with lenders looking beyond your credit score and focusing on the specifics of your business, prior experience, and the property in question.
What is a commercial construction loan?
A commercial construction loan is a loan that is used to finance the construction of a commercial building. The loan is typically used by developers and investors who want to build office buildings, retail space, or other types of commercial property.
In most cases, the loan is used to finance the purchase of the land, the construction of the building, and the cost of the construction materials. It is typically repaid over a set period of time, with interest, and is secured by the property in question.
What are commercial construction loans used for?
When you’re ready to build your own retail space, office, warehouse, multifamily or other building, you’ll need a commercial construction loan. These loans differ from home construction loans because they’re used for business purposes and have distinct requirements.
Commercial construction loans are usually used to finance the construction of a new commercial property, such as an office building, retail space, or warehouse. The loan is typically used to pay for the land, the construction costs, and the architect and engineers. Once the property is completed, the loan is usually paid off with the proceeds from the sale of the property.
If you’re planning to build a commercial property from scratch or make significant renovations to an existing one, you’ll likely need a commercial construction loan. But what are the requirements to get approved for one of these loans?
Create a plan
First, you’ll need a detailed business plan for your project. This plan should include a budget, timeline, and scope of work. Lenders will want to see that you have a clear plan for how the project will be completed and that it is feasible.
Come up with collateral
Next, you’ll need to provide collateral. This can be in the form of property, equipment, or even cash. Lenders want to see that you have something to back up the loan in case you can’t repay it.
Pass a credit check
You’ll also need to have a good credit history. Lenders will pull your credit report to see if you have a history of making late payments or defaulting on loans, as well as your business credit. You’re more likely to be approved for a loan if you have a strong credit history.
Get through underwriting
Each lender is different and has its own unique underwriting process. Before you’re able to get funding for your commercial construction project, you’ll need to pass strict underwriting requirements that look at your credit, business experience, the property itself, and other factors lenders use to determine whether or not lending to you is a good bet and that as a business owner you can afford the monthly payments.
Commercial construction loan eligibility
Fees and interest rates will vary depending on market conditions and the individual lender. As a general rule, rates and fees increase in concert with risk or leverage. If there’s more risk or more leverage, the lender sees higher costs- which are passed on to you, the borrower. Other variables like borrower liquidity, creditworthiness, and construction experience all factor into your total cost of capital.
Keeping in mind that your mileage may vary, here are a few sample loan programs you might find out in the wild.
Commercial construction loan example: Conventional lender
- Between 3-6% interest
- Loan funds 50-75% of the total project cost, also known as LTC or “loan-to-cost”
- In most cases, loans are funded within 60-90 days
- Very strict credit requirements and a detailed look at your financial history
- Rigorous underwrite covenants and stiff prepayment penalties are common
- Often have additional deposit requirements as well as concentration limits for asset classes and markets or for specific borrowers
- It can be near impossible to change or modify construction loan terms halfway through a loan process
Commercial construction loan example: Hard money and private lenders
- Between 7-14% fixed rate interest
- Typically between 75-90% LTC
- Less cash at closing compared to conventional lenders, with some lenders funding up to 80-90% of the total project cost
- May also use land as equity
- Less stringent net worth, construction experience, credit, and liquidity requirements
- Generally between 15-60 days to fund
- Typically do not have covenants or deposit requirements
Commercial construction loan breakdown
Conventional lenders tend to have lower interest rates, which comes with a cost. They have lower leverage, which necessitates you to put down more cash and make more equity available as collateral. The loan process also tends to be more difficult. Hard money and private loans tend to have higher rates but offer up loans more in line with the total cost of a project. This allows you to put less cash down, making it easier to qualify for a loan and faster to close.
Types of commercial construction loans
Construction financing is a type of short-term loan used to finance the costs associated with the construction of a new home or other real estate project.
A bank or other financial institution typically issues the loan, and the borrower is usually required to make interest-only payments during the construction period. After the project is completed, the loan is generally refinanced into a long-term mortgage.
Construction financing can be used to finance the purchase of raw land, horizontal development (also known as site work or infrastructure), vertical construction, or a combination of all three.
Raw land loans
Raw land loans are typically issued by local banks or credit unions and are used to finance the purchase of undeveloped land.
Horizontal development loans
Horizontal development loans are typically issued by national banks and are used to finance the site work and infrastructure associated with a new construction project.
Vertical construction loans
Vertical construction loans are typically issued by commercial banks and are used to finance the construction of the actual building.
Post-construction loans are typically issued by local banks or credit unions and are used to finance the final stage of a construction project, such as purchasing furniture and fixtures or installing landscaping.
Commercial construction loan programs
The Small Business Administration CDC/504 loan is a popular choice for commercial construction borrowers. This is due to several factors, including its competitive interest rates, low down payment, and relatively relaxed credit score requirements, with borrowers needing a score in the high 600s to qualify.
If you’re approved for a SBA 504 loan, you’ll receive funding for up to 40% of the costs to create new facilities, buy or improve land, or refurbish and renovate an existing operation. The SBA-approved, certified development company will fund up to $5 million, with 50% of project costs paid for by another lender and the last 10% paid by the borrower. Repayment terms range between 10-20 years, with interest rates set by the Fed.
SBA CDC/504 loan quick facts
Here are a few important facts about SBA CDC/504 loans:
- The SBA will only fund up to $5 million, but there is no cap on the total value of the project, assuming you’re bringing in outside funding.
- SBA CDC/504 loans have financing options of either 10 or 20 year terms.
- Myriad fees include CSA fee, CDC servicing fee, guarantee fee, and various third-party fees.
- There may be prepayment penalties
- A personal guarantee is required for anyone that owns 20%+ of the business.
- Collateral is required and typically comes in the form of the underlying real estate or business equipment.
- Your down payment will usually be between 10-30%
SBA 7(A) loan
The Small Business Administration also offers up the 7(a) program, which borrowers can leverage to purchase or buy commercial real estate. Like the SBA CDC/504 loan program, borrowers can receive up to $5 million in funding, but terms are a bit longer, with 25 years as the max loan term. Interest rates for these loans are based on the prime rate plus a max addition of 2.75%. Borrowers need to have a credit score in the high 600s as well as a down payment of between 10-20%.
How do owner commercial construction loans work?
Commercial construction loans are significantly different from the standard mortgage loan you might be familiar with. In most cases, loans are structured in a way that the borrower gets the total amount upfront and makes payments on the loan over a set period. For example, say you want to purchase a 500k residential home in suburban Philadelphia. You apply for the loan, the lender approves and transfers the lump sum, and you pay the lender for the next 15, 25, 30 years, etc.
But with construction loans, the borrower does not receive the total loan amount upfront. Rather, the borrower has to work with the lender to create a “draw schedule,” which is an outline that tracks and authorizes spending as your project passes new milestones. For instance, the first “draw” of the draw schedule might be for funds earmarked to pay for the initial clearing of the lot.
After, the next draw might be disbursed after the building’s foundation is poured, or power lines are put in, and so on for each subsequent project milestone and draw. In most cases, a lender will require periodic inspections to confirm each milestone. An inspector will confirm that your project has passed a certain stage, like the foundation being poured, and the lender will release the next draw until the project is finished.
Most of the time, when you take out a construction loan, you’re only responsible for paying interest on the portion of that loan that’s already been disbursed. For example, let’s say you’re taking out a $600,000 loan, and your draw schedule is set to release in six milestones of $100,000. You’ll only pay interest on the amount released by the lender- so if you’ve completed 3 milestones and borrowed $300,0000, you’ll only pay interest on that amount- not the $600,000.
After completing your construction project, you’ll have to pay the balance in full. If you don’t happen to have the balance lying around in your couch cushions, you can take out a commercial mortgage in which the property serves as the mortgage collateral. You can also use the funds you receive from the mortgage to pay down the commercial construction loan.
Describe the commercial construction loan process:
Step 1: Get in touch with a commercial lender.
Find a lender, either a traditional lender or a hard money lender. They’ll want a brief overview of your project and your background, and the lender will also run your credit at some point. Lending terms and financing guidelines change from day to day and lender to lender, so shop around to ensure you’re getting the best deal.
Step 2: Get through underwriting.
Once you’ve submitted your loan application, the lender will look over the app and decide on whether or not to approve your loan. During this process, the lender looks at several things, including the cost of your project, any summary projections, your background, and any underlying assumptions.
If the lender decides they want to move forward with the loan, they’ll usually give you what is called a “loan term sheet.” This document outlines all of the specific terms and conditions of the loan- with the caveat that the information you provide is accurate.
After you review and accept the term sheet, the commercial construction lender will move on to the underwriting process. This means they’re going to organize and analyze all of the information related to the project, including items like:
- Building plans
- General contractor bids
- Cost projections
- Construction timelines
- Your or your company’s tax returns
- Relevant financial statements
- Any other project-specific data that’s relevant to the loan
A major distinguishing factor separates a commercial construction loan from the average investment real estate loan. From an underwriting point of view, the construction loan has no significant operating history to underwrite. This means the property’s valuation is solely based on the real estate pro forma.
The credit approval process is similar to other types of commercial loans, but commercial real estate loans have substantially more risks involved. Due to this added risk, lenders rigorously examine the general contractor, development team, underlying market conditions and the existing property.
Once the loan has been approved, the lender will give you a “commitment letter.” This letter outlines much of the same info as the term sheet but also serves as a legally binding contract, while the term sheet is non-binding.
Step 3: Review your loan agreement and closing documents.
After you’ve committed to the loan terms, you’ll be given a closing checklist that details what you need to complete before the loan closes and you receive funding. Any funds are distributed on the draw schedule we discussed earlier.
What fees do you have to pay with a commercial construction loan?
There are several fees typically associated with taking out a commercial construction loan. While the fees can add up, they can be cheaper than other loan options like a typical business loan (i.e. line of credit) and definitely are better than financing the project with credit cards.
The application fee is the fee charged by the lender to process your loan application. This fee is typically a percentage of the loan amount, and it’s paid when you apply for the loan.
The origination fee refers to the fee charged by the lender to originate, or create, the loan. This fee is also a percentage of the loan amount, and it’s paid when the loan is approved.
And finally, the inspection fee is the fee charged by the lender to have the property inspected by a third party to ensure that the construction is progressing as it should. This fee is also a percentage of the loan amount, and it’s paid periodically throughout the construction process.
In addition to the three main fees, there are also a few other fees that you may have to pay, depending on the lender and the loan terms.
The lender charges appraisal fees to have the property appraised to make sure that it’s worth the loan amount. Appraisal fees are typically a percentage of the loan amount, and they’re paid when the loan is approved.
Closing costs refer to the costs associated with closing the loan, such as title insurance, attorney’s fees, and recording fees. Closing costs are usually a percentage of the loan amount, and they’re paid when the loan is closed.
Commercial construction loan specific fees
Keep in mind that fees will vary from lender to lender and even deal to deal. Further confusing the matter, different lenders have different names for the same fee. Alongside the above-listed fees, you may see some of the following fees at some point during the commercial construction loan process.
- Documentation fees
- Fund control fees
- Guarantee fees
- Processing fees
- Project review fees
Joshua Holt is a licensed mortgage loan originator (NMLS #2306824) and founder of Biglaw Investor. His mortgage expertise lies in the areas of professional mortgage loans, particularly for lawyers, doctors and other high-income professionals. Prior to Biglaw Investor, Josh practiced private equity mergers & acquisition law for one of the largest law firms in the country.