Is A Construction Loan Right for Your Next Commercial Real Estate Project?

With so many options on the market, deciding how to finance your next commercial real estate project can be challenging. You might want to consider a construction loan, which provides the funds you need to build a property from scratch or renovate an existing asset. This loan differs from a conventional mortgage because it is funded based on a future development rather than an existing property.

Construction loans have pros and cons, and other financing types might better fit your situation. This guide will help you understand the different options for short-term loans so you can make better investment decisions.

What Is a Construction Loan?

A construction loan is a type of specialty financing that can fund the development or renovation of a commercial property. Unlike traditional mortgages with 15- to 30-year terms, construction loans usually have a two or three-year duration with options to extend the loan.

Because they have a short time frame, you'll need to provide your lender with a timeline and detailed construction plans during the application process. If accepted, your lender will release funds at different stages of your project, normally to your contractor.

You can use a construction loan to cover the costs of:
•    Land acquisition
•    Building materials
•    Labor
•    Landscaping
•    Appraisal, project review and inspection fees
•    Permits and licenses
•    Appliances
•    Closing and financing costs

After taking out a construction loan, you'll typically only pay interest on the loan while construction takes place. Loan proceeds are released monthly through a construction draw process. The construction draw process entails submission of documentation, such as invoices, lien waivers and AIA documents, evidencing the work for which funds are being requested. Upon submission of a complete construction draw, a property inspection and evidence of clean title, the lender will release funds to the borrower and/or contractor. Upon completion and stabilization of the property, the construction loan is often refinanced into a permanent, longer-term loan.

Various lenders offer construction loans for those who want to invest in commercial real estate. However, interest rates will vary. Generally, these loans have higher rates than traditional mortgages because lenders see them as higher risk. These loans generally will have a floating or adjustable interest rate that correlates to the Secured Overnight Financing Rate (SOFR), PRIME or another market index rate.

You might use a construction loan to fund the following property types:
•    Multifamily properties
•    Office buildings
•    Industrial facilities
•    Retail stores or shopping centers
•    Hospitality properties
•    Mixed-use developments
•    Undeveloped land for sale

Construction Loan Types

The different kinds of construction loans you should know about include:

Construction-Only Loans
A construction-only loan provides funds to build or renovate a commercial property, but you'll need to pay everything back at the end of the loan term, which is usually two or three years. Some investors might pay off the debt in cash or take out a mortgage to fulfill their obligation.

Construction-to-Permanent Loans
A construction-to-permanent loan converts to a permanent mortgage at the end of the loan term, usually with a duration of 15 to 30 years. You can choose a fixed-rate or adjustable-rate mortgage, depending on your circumstances.

Construction-Completion Loans
In some scenarios a lender is willing to provide a construction loan during the middle of the construction process. This generally occurs when cost overruns occur or there are timing delays.

Construction Loan Pros

Taking out a construction loan has several advantages, including improved cash flow, flexible loan terms and a flexible draw schedule.

Flexible Loan Terms
As mentioned, lenders will likely want to see a construction timeline and detailed procedures for building or renovating your commercial property before releasing funds. Depending on these plans, a lender might give you more flexible loan terms than a traditional mortgage. For example, they might allow you the option to extend the loan for an additional one or two years.

Flexible Draw Schedule
With a construction loan, you can ask your lender to release funds at different phases of your project. That means you won't receive a lump sum payment at the start of your loan term, which could lower the interest you eventually pay.

Improved Cash Flow
You only pay interest on your construction loan until the end of its term, which can free up cash flow since you won't have to cover the principal. That might benefit some investors who need available cash to support other business interests.

Construction Loan Cons

Despite the benefits above, a construction loan might not suit your needs. Here are some downsides to this type of financing:

High Interest Rates
Construction loans are unsecured, so they carry an element of risk for lenders. As a result, these loans come with higher interest rates than traditional mortgages, meaning you'll pay more money in the long run.

High Risk
A construction loan can also be risky for you as an investor. If issues occur during your project, depending on the guaranties, you may still need to pay back what you owe or complete the project even though it is not lucrative. Challenges can occur when building a new commercial property, including budget overruns, labor shortages, supply chain slowdowns and zoning or permitting challenges.

Hard to Qualify For
Because of their risk, investors may find it hard to qualify for a construction loan. Lenders will ask for a detailed timeline and plan for your project before deciding whether it's feasible. They will also want assurances that you can pay back what you owe at the end of the loan term or can afford a permanent mortgage at maturity. Lenders will generally look for a guarantor that has a net worth of 100% of the loan amount and a liquidity of 10% of the loan amount.

Alternatives to Construction Loans

Other ways to finance your next commercial real estate project include preferred equity, cash-out refinances or the commercial bond market.

Preferred Equity
A preferred equity partnership can often times provide additional funding to complete renovation projects at the property. While preferred equity generally does not fund a majority of the capital stack, they may have partnerships with other lending institutions that can provide a “stretch senior” inclusive of the preferred equity.

Cash-Out Refinance
A cash-out refinance replaces a mortgage on a current property with a larger loan, providing you with extra cash. You might choose to use these funds to build a new property or complete renovations on the current property.

Commercial Bond Market
If working with a credit rated tenant that is credited by one of the major agencies – S&P, Moody’s or Fitch – you may have the ability to secure a bonded financing structure. This occurs when an investor provides funding based on a commercial bond spread for the credit tenant. This can prove to be very lucrative with funding based on pre-determined cash flows.

Final Word

Construction loans are short-term loans that can fund the building or renovation of a commercial real estate investing opportunity. Typically, you pay higher interest on these loans than on conventional mortgages, but you could benefit from more flexible terms and improved cash flow.

While these loans aren't the right solution for every investor, they could prove useful if you plan to build a new asset or renovate an existing one. Alternatively, consider a, cash-out refinance or bond market financing.