What Are Commercial Construction Loans?
A commercial construction loan is a type of loan used to finance the costs associated with the construction or renovation of a commercial building. The funds can be used to cover multiple materials and labor for the construction of a new commercial building, renovation of an existing property, or the purchasing and development of business loan for building construction.
How Do They Work?
Most loans are structured so that the borrower receives the loan in a lump sum at the beginning of the project. The borrower then pays back the loan through scheduled payments over a period of time. Commercial construction loans differ in that the full amount is not received up front. Instead, the borrower works with the lender to create a draw schedule, with partial amounts of the loan being released as various milestones are reached. A lender typically requires an inspector to ensure that each milestone has been completed before releasing the next portion of the loan.
With a commercial construction loan, you only pay interest on the amount released at any given time. So if you have only received $100,000 out of a $300,000 loan, you will only pay interest on $100,000.
Here are some other aspects of commercial construction loans to know about.
The interest rates for commercial construction loans tend to fall in the range of 4% and 12%. Of course, the higher your credit score, the better your interest rate will be. The lender you work with will also play a role in determining your interest rate--banks typically have the lowest interest rates, while money lenders have the highest.
As with any loan, there are several fees that may be associated with a commercial construction loan, including:
- Guarantee Fees
- Processing Fees
- Documentation Fees
- Project review Fees
- Fund control Fees
A down payment is required to take some of the risk off the lender. Typical down payments range from 10%-30% of the total project cost. Conventional lenders typically look at what is called the loan-to-cost ratio, which is the total amount of the loan requested divided by the total project cost. If a business is asking for a $165,000 loan for a project that costs $200,000, for example, the loan to cost ratio would be 82.5%. Most lenders require a loan-to-cost ratio of 80% to 85%.
Types of Commercial Construction Loans
There are several different types of commercial construction loans available, based on the needs of your project. These loans include:
- Land development loans, which are used for purchasing and developing land for a commercial property. They can also cover things like installation of water, sewer, and power lines on the construction site.
- Acquisition and development (A&D) loans, which are typically used on land that is not yet developed. This loan gives you the funds for both purchasing and developing the land and can sometimes be used to cover improvements on the infrastructure of existing buildings.
- Mini-perm loans, which are used to cover the costs of labor and materials during the construction period. It is also known as an interim loan, as it usually lasts between 18-36 months and is paid off in full once a permanent mortgage loan for the property can be secured.
- Takeout loans, which are permanent mortgage loans put in place after short-term loans run out. Projects that are considered to be risky may require the borrower to secure a takeout loan before they can be approved for a mini-perm loan.
How Do Lenders Evaluate Eligibility?
When considering an application for a commercial construction loan, lenders will look into a few details.
These are high-risk loans, so lenders will be looking for low-risk borrowers with high credit scores. Requirements vary by lender, but you should aim for a score in the high-600s and above if you want to be approved. Some lenders require credit scores above 700. Your business’s credit score will also be looked at.
Debt-to-income (DTI) ratio
This ratio shows the relationship between the income and the debt of your business on a monthly business. It gives the lender an idea of how likely you are to be able to cover the costs of a loan with the money your business is bringing in.
The DTI formula is Total Monthly Debt Payments / Gross Monthly Income = DTI.
Debt service coverage ratio (DSCR)
The DSCR shows the relationship between the income and the debt of your business on an annual basis.
The DSCR formula is:
Net Operating Income / Current Annual Debt Obligations = DSCR
The higher the DSCR, the better. Most lenders require a DSCR of at least 1.25. That means that after your annual debt payments, you generate a 25% profit.
Types of Commercial Construction Loan Programs
SBA CDC/504 Loan Program
The Small Business Administration (SBA) CDC/504 loan is one of the most popular loans used for commercial construction. These loans come with low down payments, competitive interest rates, and credit score requirements in the high-600s. With this loan, a SBA-approved Certified Development Company funds 40% of the costs to build new facilities, renovate existing facilities, or purchase/improve land. Borrowers can typically borrow up to $5 million.
SBA 7(a) Loan Program
Through this loan program borrowers can receive up to $5 million, and the repayment terms may go up to 25 years. The interest rates are based on a prime rate, plus a maximum of 2.75%. Qualifying for this type of loan typically requires a credit score in the high 600s, and a down payment between 10% and 20%.
A traditional bank loan is always an option. With these loans, rates, repayment, and down payment requirements vary. Generally, a down payment of at least 10% is required, and maximum repayment terms of 25 years are standard. Fixed and variable rates are available.
When a loan-to-cost ratio is lower and the borrower needs additional options, they can secure a mezzanine loan, which is secured with stock. If the borrower defaults on this loan, the lender can convert to an equity stake in the property. With this type of loan, the borrower has more leverage and can achieve a loan-to-cost ratio of up to 95%.
Construction Financing with Amplify
If you are looking into construction financing, it generally means your business is growing--congratulations! But it’s easy to be anxious or unsure about the process. Take the time to understand your options and what will be required of you before diving in. Talking with a local commercial loan officer can make the process more streamlined and less stressful.