I get at least one phone call a day requesting construction financing. (Owens Financial Group does fund commercial construction projects on a limited basis.) Underwriting a construction loan is handled differently than a typical commercial loan.
Lenders desire to know that a developer has enough money invested in the project to motivate the developer to overcome the headaches and hassles that are bound to arise during development. A developer with too little invested, is likely to cut their losses and run, if construction problems arise, permits are not obtained, or weather is not favorable. Many lenders will underwrite a construction loan on a Loan-to-Cost (LTC) basis, as well as a Loan-to-Value (LTV) basis.
Loan-to-Cost
LTC is a ratio of the loan amount to the total project cost. Included in total project cost are all of the costs from the time of acquisition to the close of escrow.
Cost Categories
Costs can be divided into two general categories Pre-Development and Development costs. Pre-development costs are those costs incurred before any actual construction work has begun on the property. This includes architectural fees, engineering, survey, legal, entitlement, and permit fees. The property acquisition price, site work, and utility installation may also be included in this cost section. Development costs are those incurred during the actual development of the property. Development costs include site work, material costs, labor costs, overhead, loan fees and interest, landscaping, insurance, and taxes.
Sources and Use of Funds
Many lenders will ask for a spreadsheet or report that details where money was spent and the source of that money, borrower’s funds or loan proceeds. Again, this is used to determine the developer’s investment in the project.
The Devil is in the Details
Different developers account for costs differently and lenders might view developer “costs” differently. Commonly this occurs when a developer has little actual cash left in the project. The developer is trying to appear more invested in the project.
Below are some common cost “red flags” for underwriters:
Interest during the pre-development period. This is indeed an expense, however it has not added value to the land or property. Interest has no value to a future buyer, while entitlements, site work, or utility installation may.
Property acquisition price vs. property “value”. Borrowers on construction loans will often state the property cost based on a current market value. Asking when the property was purchased and the initial purchase price is a key to unraveling this knot. Value can be attributed if the borrower has taken the property through entitlement or assembled multiple parcels of land and is developing a larger project.
Management or supervision fees during development. Most lenders expect the developer to get paid upon completion and sale of the project, not before the construction lender’s risk is paid off.
Single builder/developer projects. If the developer is also acting as the builder, the cost figures might be lower than market costs for similar construction. Should the developer be unable to complete construction, the lender is going to incur a higher construction cost to bring the project to completion.
The Wrap Up
Lenders are always trying to mitigate their exposure to risk. A well capitalized developer, that is invested in the project is more likely to bring the project to completion and to mitigate the lender’s exposure to risk.
Funding construction projects requires gathering the proper detail from the borrower. It also takes an understanding of lender requirements. Different lenders will ask for different documents and schedules. Knowing in advance what they require and acquiring that information from the borrower will speed your loan approval process.
Happy New Year and Success in 2008!
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