Construction Loans
by Robert J. Abalos, Esq.
from investinginland.com

How to get construction loans is a frequent question I'm asked by visitors to my website at www.investinginland.com. So here is some advice on how to deal with the banks and get the money you need to build on your land.

What are Construction Loans?
To be simple about it, construction loans are any loan that funds the construction, development, modernization, rehabilitation, or renovation of a real estate project. Construction loans are used to develop raw land and also improve or rehab an existing building.

Construction loans by definition are short-term loans that only exist during the period of construction. Lenders and developers alike expect that these loans will be replaced by permanent financing at the end of the project. Since constructions loans are meant to be "taken out" by other financing, these newer and more permanent loans are often called "take-out" loans. It is very common to hear developers looking for take-out financing.

Construction loan costs are usually fair to developers. Obviously the rate your lender charges depends on how good your credit is, the viability of your project, and other practical considerations, but a fair rule of thumb would be for the interest rate to be 4-5% above the prevailing prime rate at the time the loan is written. The same fairness applies to construction loan LTV ratios. Many lenders require LTVs at around 70-75% but it is quite common for some to lend up to or beyond 100% for reasons that will be explained later.

Most construction loans are established as new first mortgages with a lien attached to the property or land under development. If there is existing financing on the property, the lender almost always requires the current lienholders to subordinate in order to make the construction loan. While this may seem unfair, two reason dictate why it is not. First, the construction loan is short-term financing and will be replaced by permanent financing that will likely incorporate the existing liens into a new take-out loan. Therefore it is in the current lienholder's interest to subordinate, they will get paid off faster that way. Plus, the extension of construction loan credit adds security to the current lienholders by raising the value of their collateral. Owning a mortgage secured by raw land is okay, but having the same mortgage secured by raw land plus a finished building is better. So while the current lienholders may be pushed down one position in the priority order after subordination, they actually have better security for repayment than before.

Often construction loans work on a disbursement schedule, in other words, you do not get the full amount of the loan at one time and the capital is released in stages. Lenders differ widely about what they require. Some have a "three/thirds" schedule, or releasing 1/3 of the proceeds when building framing is complete, another 1/3 when the building is "tight" or waterproof and complete with rough plumbing and electrical work done, and the final 1/3 when the building or project is finished and a certificate of occupancy issued. Other lenders use a house-by-house schedule, for example, if you are building ten houses on some land they will release 1/10th of the funds as you complete each home. These money releases operate on what are called "draw schedules" and even four, five, six or more separate draws are common. Lenders will specify in writing what specific work needs to be done to qualify for a draw and will require inspection to prove the work is done for each draw before releasing any money. The cost of these inspections is paid for, you guessed it, by the mortgagor although it is common for these costs to be rolled into the permanent take-out loan.

If you are developing some land where you will be building a number of homes or housing units on spec or will be directly selling some building lots to other developers, a lender will usually require that you get a commitment letter from another lender (if they're not interested) for permanent take-out financing BEFORE they will write the construction loan. This is quite fair to both the construction lender and developer, although many builders do not see it that way. Since a construction loan is short-term, the lender making it wants reassurance that they will be paid off quickly before making the loan. As you might have guessed, this is called a take-out commitment.

When building lots or new houses are sold on property where a construction loan lien exists, part of the construction lien is released when title to these sales is transferred and new permanent financing received from the new lot or homeowners repays the construction loan. But what if the building lots or new homes do not sell as planned and the developer is stuck with many still in inventory when the construction loan's term expires? This is where the take-out commitment protects the construction loan lender. The developer's new permanent take-out financing pays off the construction loan on whatever units or lots remain unsold and they remain as security for the take-out mortgagee.

Construction Loan Tricks-of-the-Trade
First, when applying for construction loans try to have your take-out commitment already in hand. Lenders love when they see another lender already backing them up on a deal in case things don't go as planned.

Second, sell the construction loan from the lender's perspective and not from your own. Lenders want these loans to be SHORT and FULLY SECURED. That means work out the shortest realistic timetable for your project and pre-arrange subordination agreements if you need to do so. Provide lenders the same information you would provide equity investors. If a project is viable and will make money, lenders will likely fund it. If the project is marginal or adds inventory to an already glutted market, you sales job is much tougher.

Third, when you are dealing with a lender anxious to make construction loans, push the LTV issue all the way to the max. Banks are like all other businesses, sometimes they run "sales" and are more likely to write loans than at other times. Management of banks and lenders is no different from selling hamburgers or TV sets sometimes. While all lenders will have a written policy on LTV ratios for construction loans (or at least claim they do), the key place you can push as a developer is loan-to-value of what? Is it the value of the current collateral that is at issue or the future collateral once construction is completed?

Take, for example, this situation. Dave Developer buys a $200,000 piece of land and wants to build an apartment building. He goes to a bank where the policy is to write construction loans with 80% LTV ratios. His costs in addition to an estimated $800,000 construction budget are these:

$20,000 for zoning approval

$75,000 in soft development costs

$75,000 in construction loan interest

Dave does not want a loan of $800,000, or the actual amount of his construction budget. This is what a lender will likely offer him, after all, the loan is for construction, right? But Dave can make the clever argument successfully that the real cost of this development is $1,170,000 and therefore the bank could easily loan him $936,000, or a conservative 80% LTV on the value of the finished project's cost.

But Dave can even go further. What if he argues that the LTV ratio should be applied against the actual market value of the finished building? Here he proves the finished apartment building would be worth $1.5 million so an 80% LTV loan would be $1.2 million.

Of course, all this would depend on Dave's prior relationship with this lender, his credit history, the bank's assessment of this project, and other factors but he would be absolutely for attempting to cash out before the project is finished and so should you when banks are hungry to make these loans.

Fourth, try to structure your construction loans as lines of credit rather than draw down loans. Draw downs are time consuming and frustrating sometimes. What if an inspector can't get to a job site for a week but your subcontractor needs to be paid TODAY? What if there is a controversy on whether an item is completed or finished? Relying upon banks to release funds on time is often like getting your brother-in-law to repay his debts to you. You want to exert some pressure, but how? You need the long-term relationship just as much as you need the money. Many lenders will use the line of credit concept where you can draw funds as needed if your credit is good and your experience as a developer is sound. It's worth paying a half-percent extra on the loan or a point to work out a credit line rather than having to deal with draw downs.

Lastly, AVOID playing draw down games with your contractors and subs. It is a well established and in my opinion highly unethical technique to keep pushing the payments due to contractors and subs back beyond the draw down payment schedule in order to keep a larger than projected amount of cash in your pocket. For example, if 1/3 of the funds are to be paid when framing is complete, promising to pay your framers and foundation contractors when the building is tight (the second 2/3 draw down) means that they are waiting to be paid for completed work while the bank's cash to pay them remains in your checking account. I've seen some developers so skilled at playing this game that their foundation and framer contractors were paid by the security deposits received from tenants on the finished building! Treating your builders badly is a recipe for the inevitable mechanic's lien. Stick to your payment schedule as closely as possible. If you have the bank's cash, use it. Your contractors and subs will remember how you treat them on current projects and determine how they will treat you on future ones.

The Bottom Line on Construction Loans
Construction loans are actually much easier to get than people often think. They are short-term loans so the lender has a limited risk. With careful project planning, it is quite simple to get one even if your credit is not perfect.

As my Investing in Land Home Study Course teaches, land owned free-and-clear is a blessing to developers and is the most powerful asset in their possession. Construction loan lenders love free-and-clear land, they often will finance construction just based on the value of the land itself. Plus there is no subordination issue when you own the land without other liens. The result is that if you can acquire free land like my Course teaches, you virtually guarantee construction of something on it at little or no additional cost to you, making the rental income or capital gains upon resale of this project pure profit in your wallet.

The bottom line is realize that construction loans represent only one way of building on land. Cash is cash and you can use equity capital, loans on other collateral you own, or about three dozen other cash sources as a way of paying for construction. You do not have to get a construction loan to do construction. My advice is that when construction loan financing is easy to get, use it and use it often. But when the banks and lenders are being tightfisted towards these loans, use capital from other sources. You don't need to beat your head against some banker's desk to get a construction loan when really any other source of cash will do just fine.