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With the Fed raising interest rates throughout 2022 to stem inflation, commercial construction projects are expected to decrease significantly. Overall, construction is down about 5% from pre-pandemic levels, but an uptick is expected in the coming year to bring construction levels back to the level seen in 2019. Anticipating this growth, business owners and developers should begin their search for funding in preparation for construction projects in 2023.
In this guide, we’ll look at the nature of commercial construction financing, how it’s structured, and how business owners can go about securing this funding.
Whether you’re building a new structure ground up or doing extensive renovations on an existing one, there’s a good chance your business will need a construction loan. Getting funding for construction isn’t all that different from a mortgage used to purchase a building outright. Traditional banks, the Small Business Administration (SBA), and online lenders are all options for securing a construction loan where they differ from mortgages in their structure.
Construction loans are considerably more complicated compared to standard mortgages. The lender and borrower must negotiate how much funding will be released at different project stages. This requires meticulous budgeting on the part of the borrower and adherence to a strict schedule.
Most real estate loans are funded in a lump sum, but construction loans are usually given out piecemeal. The terms of the loan lay out the project’s stages, with funding occurring in stages and upon a project meeting agreed upon milestones (e.g. clearing and leveling the land, completing the foundation, passing an inspection, etc).
This is known as the draw schedule, and it ensures the project manager and/or contractor is utilizing funding properly. Arranging the funding into stages is advantageous to the borrower as interest is only levied on the money that’s been dispersed rather than the total amount of the loan. Payments are typically “interest only” until all funds are disbursed.
Unlike traditional mortgages, there’s not a finished asset for the lender to repossess should the borrower default, and that added risk necessitates higher interest rates. Therefore, most commercial building construction loans have interest rates between 4 and 12%.
Once it’s complete, the borrower will usually refinance the loan with a different lender or restructure their interest rates and payment schedule with the lender providing the construction loan.
Unlike mortgages, construction loans aren’t designed as long-term sources of financing. While you might only pay interest on the loan during the construction project, the principle must be paid off quickly after the project’s completion. This is known as a balloon payment system, and it differs significantly from a traditional mortgage’s fixed monthly payments.
AVANA Capital lends to investors who hold the asset and seek a tenant to cover the cost of permanent financing. Once construction is completed, the property can be used as collateral for a new loan. The construction loan will be converted into a permanent loan. This may require finding a new lender or working with your existing lender to secure permanent (long-term) financing for your property.
While first-time homebuyers can put down as little as 3% when buying a house, construction loans are much riskier and require at least a 20% down payment. Fortunately, if you own and have paid off the land where construction is taking place, you can include your equity in the land towards the loan’s down payment requirements.
The lender will also want to know all of the construction project’s details:
The lender will require that the project budget includes an adequate allocation for cost overruns. These funds might be part of the project’s budget or be contributed by the borrower. Lends will require an appraisal to be completed on the front end of the project to determine the as-complete value. Once complete, the property’s appraisal will need to be ratified or updated to match the value as necessary.
Securing a commercial construction loan can be a complicated process. AVANA Capital has a long track record of successfully financing commercial construction loans and can guide you through the entire process. We also offer flexible refinancing options once the project is complete.