How Commercial Construction Loans Are Structured

December 20, 2016 by Melissa C. Martorella, Esq.

Commercial construction loans can be a source of revenue that many banks count on to sustain growth. However, history has shown that taking on these loans without proper risk management in place can also create losses and add stress to a bank’s portfolio. The real estate market is extremely cyclical, with peaks and declines that can be difficult to predict accurately. Therefore, lending practices that adhere to certain guidelines can help minimize losses for both lender and borrower. Lenders must mitigate their potential for losses by monitoring the development project throughout the entire process. This ensures milestones are met and funds are distributed as needed to sustain construction through to completion.

Construction lending is not the same as lending on an existing property. It takes a mortgage professional with experience in this niche market to ensure risk is evaluated correctly and the lender’s money is secure. It is the lender’s duty to monitor the conditions of the markets where they are active in construction finance so they can apply the best lending strategies for their borrowers.

Economic conditions do not impact all real estate sectors equally. The demand for office space depends on the amount of office-related businesses in a particular locale. The demand for retail space is affected by the state of the economy and consumer spending habits. In the residential sector, demand is influenced by the affordability of homeownership in particular neighborhoods, interest rates, and stability of employment. Lenders need to have a clear understanding of local markets and their economic indicators to aid in determining the practicality of commercial construction projects.

A commercial construction loan typically has had a bit of work done on the project before a loan closing. The project developer must have already concluded some items, including negotiating a parcel purchase, obtaining title insurance, developing a project plan, consulting or hiring an engineering, procurement, and construction firm (EPC), and obtaining the necessary city or state permits for the project. The mortgage broker or lender will then work with the borrower to negotiate a funding priorities list, draw-down plan, and repayment schedule. The lender will also negotiate the terms of the loan, and if they are acceptable, schedule a site visit and underwriting overview of the entire project before proceeding to a loan approval and closing.

After the pre-qualification and underwriting guidelines are completed, the lender and developer will work on final agreement items like project insurance, the construction contract, and other post-closing requirements not covered in the final closing. Once these items are completed and agreed to by both parties, the lender is bound by the finance contract and must fund the loan as long as the borrower meets all the requirements and terms of the closing.

Once the loan funding begins, the lender is bound by the conditions of the financing agreement. The lender is successful with their investment only after the project is completed and the loan is repaid, either with proceeds from the sale of the completed property or by refinancing the project after it is occupied. While the project will have some asset value to the creditor in a default, the value of the property significantly increases once construction is complete and a certificate of occupancy is obtained.

Commercial construction loans can be a lucrative addition to a lender’s loan portfolio if they are conducted with the proper due diligence and oversight. These types of loans offer lenders a better rate of return than is typical of traditional mortgages, with the return of capital at the completion of the project. The recapitalization allows the bank to reinvest that money into another project, earning more fees in the process. Although construction loans are specialized and take a bit more effort in ensuring limited risk exposure, they can provide a substantial addition to a lender’s annual revenue stream.

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