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So, you’ve come to a crossroads where you know it’s time for your business to grow. Perhaps you are currently renting an office space and have decided it’s time to build your own building. Or your team is outgrowing your current facility and you need to expand. Whatever the reason, if you are planning on undertaking a commercial construction project, you will likely need a loan to help finance the endeavor.
A commercial construction loan is likely what you need to make your plan a reality. But before you apply for a construction loan, know what commercial construction loan requirements are necessary for you to qualify for one.
This article covers the common commercial construction loan requirements for business owners. We also touch on debt service coverage ratio (DSCR) requirements and how lenders evaluate applicants. Read on to learn what criteria your business must meet to qualify for a construction loan.
Commercial construction loans are debt financing provided to business owners planning to construct a new commercial property. The loan amount is typically based on the projected value of the property once it is complete and what a business can afford to pay. Construction loans are usually short-term, with repayment terms lasting between one and three years.
Lenders will release funds in stages as the project progresses. This is done to minimize the risk to the lender in case the project is not completed as planned.
Once the commercial property is completed and the appraisal has been updated to reflect the completed value, the construction loan will be converted into a permanent mortgage. The repayment terms of the permanent mortgage will be based on market conditions and the value of the property at that time.
Commercial construction loan requirements vary from lender to lender, but here are some of the most common.
You will need a good credit history to qualify for a construction loan. Since construction loans are typically large amounts, lenders will be looking for low-risk borrowers with a history of repaying debt.
Business owners will typically need a credit score in the high 600s at the very least, depending on the lender. The credit score requirement for a construction loan is generally higher than other types of loans because the loan is typically for a large amount and carries more risk for the lender.
In addition to a good credit score, you will need to show that your business is doing well. Lenders will want to see a strong business history with consistent revenue and profit. They will also want to see that your business has a good reputation and a strong management team.
As with any loan, a common construction loan requirement is a strong debt service coverage ratio (DSCR). DSCR is a popular benchmark used in the measurement of a business’s ability to generate adequate cash to cover its debt payments.
For construction loans, lenders typically want to see a strong DSCR, normally of 1.4 or higher. This means a business has enough to cover debt payments 1.4 times (i.e. there is cash to spare). A high number indicates a business has enough income to cover its debts.
To calculate your debt service coverage ratio for a construction loan, use this formula.
Net Operating Income / Debt Obligations = Debt Service Coverage Ratio
For example, let’s say your net operating income is $900,000 and your debt service is $600,000. This would give you a debt service coverage ratio of 1.5.
You’ll need to have enough collateral so that the lender will secure its investment if your business defaults on the loan. This collateral might include assets like equipment, accounts receivables, or other property.
When applying for a construction loan, a business should have identified a qualified builder for the project. This typically means finding a builder who has verifiable completed projects and is a member of a reputable general contractor association.
Many lenders require a detailed construction plan for the project during the loan approval process. This includes blueprints, floorplans, specifications, timelines, and more. Suppliers, materials, and labor costs may also be required details.
A business owner should also have a clear idea of the project’s scope and be able to articulate it to the lender. This helps lenders understand the risks involved in the project and whether the business owner is prepared to handle them. At AVANA, we like to say when it comes to underwriting businesses that apply for construction loans, we do not just underwrite businesses, we underwrite projects.
More construction loan requirements include a business’s current income tax returns and profit and loss (P&L) statements. Lenders want to ensure a business is in compliance with tax laws, is operating profitably, and all payments are current. At AVANA Capital, we need to see your last three tax returns and most recent P&L and balance sheet (within 60 days).
A personal guarantee is also required for construction loans. This means the business owner agrees to be personally responsible for repaying the debt if the business defaults. A personal guarantee puts the business owner’s personal assets at risk, so it’s important to understand this before agreeing to one.
A large down payment is another common construction loan requirement. The average down payment requirement ranges between 20% to 50% of the total project cost depending upon the specific lender.
These were the most common construction loan requirements. Specific requirements may vary based on your chosen lender, the type of loan you’re applying for, and other factors.
AVANA Capital is a leading lender that can offer borrowers commercial construction loans with flexible terms. Our commercial construction loans only require 20% to 35% down payments and we even offer interest-only payments for the first two years. It is our mission to serve business owners by providing fast and reliable financing.