Commercial real estate is a profitable property with the sole purpose of operating businesses, for example, retail stores, office buildings, medical facilities, hospitality centers, warehouses, and so on. However, not all companies can afford to fund a construction project independently. Hence, the finances required for the acquisition, development, and construction of commercial properties are obtained through commercial construction loans.
This blog explains how these business construction loans work, what are their eligibility criteria, and the step-by-step loan application process.
What Is A Commercial Construction Loan?
A commercial construction loan is a type of business financing to fund a new construction project.
Suppose you plan to purchase new land, construct a property from the ground up, or renovate and expand an existing space. In that case, a commercial construction loan will cover all the associated costs.
As a rapidly flourishing business in the US, construction spending amounted to $1.84 billion in February 2023, including residential and non-residential construction. Hence, being a small business owner grappling with fierce competition, you could benefit from commercial construction loans as a reliable financing solution. The Wall Street Journal reported that commercial real estate loans were up 3% year over year.
These loans differ from commercial mortgages, which are medium to long-term business financing to fund the purchase of an existing facility or the construction of a building on land you already own. Construction financing works similarly to a business line of credit where you make interest-only payments until construction and can withdraw set amounts of capital at specific points throughout the project.
What Are The Uses Of Commercial Construction Loans?
Due to its versatility and flexibility, a loan for the construction of commercial property can be utilized for financing various expenses, such as –
1. Starting or Expanding a Construction Business
If your commercial construction business is profitable and you are keen on its expansion, then securing a loan would be a smooth ride. Banks usually grant construction financing to businesses that have regular cash flow and a planned strategy to utilize the funds.
2. Purchasing New Land or Renovating Current Commercial Property
Construction business loans are specially formulated to assist property owners in acquiring new land, developing new facilities, and expanding or renovating their current spaces. As commercial real estate projects are a huge investment, most companies cannot pay for them straight away. A construction business loan empowers them to finance costs associated with location, materials, contractors, and kickstart the construction work.
3. Buying or Leasing Construction Equipment and Materials
Whether you require heavy construction equipment or building materials, a business loan can provide you with the necessary funds. Often, the rented or purchased equipment can act as collateral for the lender to obtain security from the business owner.
4. Hiring Trained Labor
Skilled labor is the cornerstone of any successful construction project or business. Hence, financial assistance is beneficial to fund workers’ training, nurturing, grant bonuses or other monetary incentives, and enhance overall productivity.
5. Stabilizing Cash Flow
Having a business line of credit helps general contracting firms cover expenses related to the management of payroll, inventory, and taxes. Furthermore, construction business loans support a company’s marketing efforts and payment of damage insurance premiums.
What Are The Different Types of Commercial Construction Loans?
There are different types of commercial construction loans, each with individual purposes and terms.
1. Traditional Commercial Construction Loan
A traditional commercial construction loan borrowed from a bank is used to finance the upfront costs associated with new construction and the purchase or renovation of existing commercial buildings. Mostly, traditional construction loans include interest rates from 4% to 12%, a minimum down payment of 10%, and a maximum repayment term of 25 years.
These construction business loans operate under a draw schedule, where funds are disbursed upon completion of project milestones. Initially, you pay only interest and then settle the principal in a single lump sum on project execution. Traditional commercial construction financing is more like a line of credit than a loan.
2. SBA 504/CDC Loan
Issued by the Small Business Administration (SBA), the purpose of SBA 504/CDC loans is to purchase and renovate long-term, fixed assets like land, properties, equipment, and facilities. You can borrow up to $5.5 million and pay it back over 10, 20, or 25 years with interest based on US Treasury rates.
The down payment ranges between 10% to 30% with the property under construction as collateral. A regional SBA-certified development company will fund 40% of your project’s costs (loan-to-costs ratio). That means you must arrange another lender for 50% of the costs and invest at least 10% by yourself.
3. SBA 7(a) Loan
This is the most common type of SBA loan issued by a private lender and partially backed by the US Small Business Administration. SBA 7(a) loans can be utilized for working capital, construction of commercial real estate, business expansion, or purchase of supplies and equipment.
The maximum lending amount is capped at $5 million with repayment of up to 25 years. The down payment rates are between 10% to 20%. SBA will guarantee 85% of funds for loans up to $150,000 and 75% for those greater than $50,000.
4. Land Development Loan
You can acquire a land development loan to purchase raw land and develop it for further construction or sale. Post land development, lots can be subdivided and sold as individual units for commercial or residential use. In addition, the construction loan covers the installation of power lines, water supply, plumbing, and sewer connections to the main grid.
5. Interim and Bridge Construction Loans
Interim and bridge loans are short-term commercial construction financing. The former is usually valid for 18 to 36 months, while the latter can be between 6 months to 2 years.
Interim loans are borrowed to finance the cost of labor and materials needed for a commercial project. A bridge loan is taken when the borrower plans to sell their property in the loan’s duration and pay back the loan, or to use that time to elevate their credit score.
6. Mini Perm Loan
Similar to a bridge loan, a mini-perm loan is short-term commercial construction financing. A mini-perm loan is often utilized to repay an overdue commercial property financing that will reap revenue once finished. Once cash flow, stabilization, or operating income is established, the mini-perm loan is replaced by long-term financing.
A bridge loan is a short-term construction business loan intended to fund a specific demand or to “bridge” a cash-flow gap. Once this cash flow is stabilized, the mini-perm loan gets replaced by long-term financing.
7. Acquisition and Development Loan
If your land is ready to be developed and needs infrastructural improvements, go ahead with an Acquisition and Development (A&D) loan. This type of financing can also be used to refurbish the infrastructure of underutilized existing buildings. An Acquisition and Development loan is primarily for covering the costs of both the land and pre-development improvements.
8. Takeout Loan
The takeout loan ‘takes out’ your short-term, high-rate construction loan. To elaborate, a takeout loan can offer long-term funding for development or construction projects and replace your temporary, short-term construction or bridge loans.
Lenders may ask you to secure a takeout loan before approving a short-term loan, especially for risky development projects.
9. Mezzanine Loan
In architectural terms, a mezzanine is a connecting floor between two main stories of a building. Speaking of commercial real estate financing, a mezzanine loan bridges debt financing and equity financing.
For example, you want to purchase a commercial property worth $4,000,000. You are able to secure senior debt of $2,500,000 and raise $900,000 in equity from investors. In this case, a mezzanine loan of $600,000 can finance the remaining purchase amount of the commercial property.
Since mezzanine loans are secured with stocks, lenders can also finance risky construction projects.
10. Construction-To-Permanent Loan
Alternatively known as CP loans, construction-to-permanent loans are a type of hybrid loan that blends short-term construction financing and long-term traditional mortgages. When construction on a property is finished, the debt automatically converts into a traditional mortgage, usually with a 15 or 30 year-term.
Because a CP loan requires the closing of only one loan, construction-to-permanent loans are also called ‘single-close construction loans’.
How Does a Commercial Construction Loan Work?
A construction loan for commercial property has a different structure from the other business loan types. For example, in a commercial mortgage, the borrower receives the full amount of the loan upfront as one lump sum. On the other hand, commercial construction loans require the lender and the borrower to set a ‘draw schedule’ for releasing partial payments.
When Does The Lender Release The Funds?
In commercial construction loans, you will plan a ‘draw schedule’ or dates with your lender according to which specific amounts of funds will be disbursed as the project hits preset milestones.
Some typical milestones in the draw schedule are:
- Development of the Land
- Laying the Foundation
- Framing of the Building
- Interior Finish
- Exterior Finish
- Final Completion
Remember, a lender will require an inspector to check that the milestone is completed before releasing the next draw.
How To Pay Back The Loan?
When you borrow a commercial construction loan, instead of paying interest on the full amount, you only need to pay interest on the portion of the loan drawn during the construction. Let’s say, the total financing amount is $500,000, however, the lender has lent you only $200,000, hence, you will be charged interest on this $200,000. You can pay off the balance entirely once the project is finished.
Post construction, the loan’s entire principal comes due. As mentioned earlier, commercial construction financing is short-term, usually lasting a few years. If you can’t afford to repay the loan within this time frame, consider refinancing with a commercial real estate loan. Your newly built property will now act as collateral. A new mortgage will bind you to more affordable, longer-term payments.
Top Construction Loan Lenders
Commercial construction loan lenders are generally banks, credit unions, and private lenders, also known as hard money lenders.
Small Business Administration (SBA)
The Small Business Administration (SBA) is the United States government agency that financially supports small businesses. They issue SBA 504/CDC loans and SBA 7(a) loans, which are popular owing to their low down payments, competitive interest rates, flexible terms, and a credit score requirement of 640+.
While 7(a) loans are issued through banks, credit unions, and private lenders, CDC/504 loans are provided by community development corporations. As the state government issues these construction loans, they have a high credibility.
Banks and Credit Unions
Banks and Credit Unions offer several options for commercial construction loans such as traditional loans, SBA loans, and mezzanine loans. Moreover, banks have competitive interest rates, different repayment terms, and down payment rates.
Though they ask for a down payment of at least 10%, repayment over 25 years is standard, and you will be able to choose fixed or variable commercial construction loan rates. Keep in mind that financing programs from banks and credit unions are the toughest to qualify for, so excellent credit and multiple years of experience in business are a must.
Private Lenders
Private lenders or hard money lenders are private corporations that offer short-term funding options secured by real estate. They can approve your loan faster and have less stringent qualification requirements than SBA lenders or banks.
Hard money commercial construction loans are a great option if you have less credit. Because of the risk involved for private lenders, hard money loans come with higher interest rates and fees.
Ultimately, the best construction loan will offer financing on your business terms with the lowest interest rates and fees.
Commercial Construction Loan Interest Rates
As a borrower, you only pay interest on the portion of the loan drawn. Commercial construction loan rates will vary from lender to lender based on your credit score, down payment rates, nature of the collateral, project risk and profit, and the debt situation. Banks will have the lowest interest rates whereas private construction loan lenders charge heavy interest rates.
On average, the commercial construction loan interest rate ranges from 4% to 17%.
Commercial Construction Loan Interest Rates
| Commercial Loan Types | Average Interest Rates |
|---|---|
| Conventional Loan | Approx. 6% - 9% |
| SBA 504 Loan | Approx. 3.5% - 6% |
| SBA 7a Loan | Approx. 5.5% - 11.2% |
| Traditional Bank Loan | Starts from 3.5% |
| Hard Money Loan | Approx. 10% - 20% |
| Mezzanine Loans | Approx. 7.7% - 11.5% |
| Construction Loan | Approx. 8.5% - 13.5% |
| Bridge Loan | Approx. 4.2% - 13.2% |
Down Payment
A commercial construction loan, especially, is considered a high-risk loan. Paying a down payment reduces some of the risks for the construction loan lender as well as the borrower, which may lower the interest rate. Conventionally, the down payment rates are between 10% to 30% of the total project costs. Rarely you will find a lender financing 100% of a construction project.
Fees
A commercial construction loan entails costs, just like any other financial transaction. The fee types and amounts may differ from lender to lender. Some of the following fees are paid during loan origination.
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Guarantee Fees
A guarantee fee is paid by the borrower of mortgage-backed security (MBS) to applicable lenders as a protection against losses due to credit-related issues. Certain portions of the guarantee fees are used to cover the issuer’s internal costs related to the security. For example, SBA guarantee fees range from 2% to 3.75%.
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Processing Fees
The amount paid to the lender for expenses of processing the construction business loan. It’s a one-time fee and cannot be refunded in case the borrower cancels the loan application later.
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Documentation Fees
Construction loan lenders charge documentation fees to cover the expenses related to the preparation of loan documents. Typically, these fees range between $50 to $100.
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Project Review Fees
Review fees are associated with the lender’s review of the construction project plans during consideration of the submitted loan application by the issuer.
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Fund Control Fees
Fund control fees arise when a third party monitors the construction budget, draws documentation, reviews the plan, and overall manages the construction loan draw process.
What Are Commercial Construction Loan Requirements?
When you seek a construction business loan, the lender will expect you to meet two kinds of loan requirements – proposed project requirements and documentation of your business and personal creditworthiness. Below are the must-have criteria:
1. High Personal Credit Score
To qualify for a construction loan, you need a high credit score, at least in the 600s. Unlike other types of financing, construction loans have higher credit score demands, because they involve larger amounts and are riskier for lenders. Hence, lenders prefer dependable borrowers with a history of repaying debts.
2. High Business Credit Score
Along with personal credit history, business credit is one of the most important commercial construction loan requirements that lenders scrutinize. The lower the business’s debt-to-income (DTI), the brighter the chances of loan approval. The debt-to-income ratio refers to the relationship between a business’s gross monthly income and its monthly debt payments. A DTI of 40% or less will pass the approval, though certain lenders have stricter requirements.
DTI Formula:
DTI = Total Monthly Debt Payments / Gross Monthly Income
3. High Debt Service Coverage Ratio
The Debt Service Coverage Ratio (DSCR) is a popular criterion to measure a business’s ability to generate enough income annually to cover its debt payments. Typically, lenders will expect your business to have a high DSCR, at least 1.4 or higher. What this means is, your business is capable of covering debt payments 1.4 times.
Debt Service Coverage Ratio Formula:
DSCR = Net Operating Income / Current Annual Debt Obligations
4. Business Profits and Experience
In addition to credit score, business owners must show a positive business history with consistent profits. Not just that, your company should carry multiple years of industry experience, a good management team, and a decent reputation.
5. Collateral
Collateral is extremely important for a construction loan lender to secure its investment if your business fails to repay the borrowed amount. Assets like equipment, inventory, accounts receivable, and properties that are being purchased, developed, or renovated can count as collateral.
6. A Qualified Builder
Prior to the construction loan application, you should hire a qualified commercial building contractor for your proposed project. The right general contractor will have a portfolio of successful projects and will be a part of the regional general contractors association, among other qualifications.
7. Detailed Construction Plan
Most lenders ask for a detailed building plan as a commercial construction loan requirement. This plan should include blueprints, floorplans, specifications, timelines, suppliers, materials, and labor costs. Articulate the project’s scope clearly to the loan lender as this helps them to assess the project’s risks and your capability to handle them.
8. Income Tax Returns and Profit and Loss Statements
Among crucial documentation include a business’s current income tax returns and profit and loss (P&L) statements. Any financial institution will ask for 3 years of tax returns from the borrower. This is a way to confirm a business is in compliance with tax laws, is functioning profitably, and all payments are latest.
9. Large Down Payment
Every construction loan lender expects borrowers to make a large down payment. The average down payment required for a commercial construction loan varies between 10% and 30% of the total project cost, depending on the lender.
10. Balance Sheet and Appraisal
A business balance sheet reflects your company’s assets, liabilities, and net worth. This will show your business’s profitability and liquidity to the lender. Also, the market value of any project-related purchase, such as land or building should be evaluated by a professional appraiser. This will help justify your construction business loan request.
Loan Application and Approval Process
The commercial construction loan application and approval process usually takes a few months, so it’s better to start early. These are the 5 major steps to secure your construction loan:
Step 1 – Contact a Local Lender
The first and foremost step for any business in need of funds is to contact a traditional lender or hard money commercial construction loan lender. Here, you should discuss all of the mandatory documentation for loan requests and inquire about the construction financing guidelines and solutions that they have. Always prefer a local lender as they are closely familiar with the local business markets.
Step 2 – Application and Review
Many lenders ask you to apply for construction financing in person, however, modern institutions now offer the convenience of online applications. After submission, the loan lender will internally review all the provided information and decide on whether to go ahead or not.
During the review, the construction loan lender examines general aspects of the project such as:
- Basic Outline of the Project
- Project Cost
- Summary Projections
- Underlying Assumptions
- Background of the Project Stakeholders and Developers
Step 3 – Loan Underwriting
If the lender decides to proceed with your project, they will provide a ‘loan term sheet’. This term sheet mainly outlines the terms and conditions of the loan. You can ask for certain changes and negotiate until you and the lender agree on the proposed terms. Once the term sheet has been reviewed and accepted, the loan request will move into the underwriting stage.
During the commercial construction loan underwriting process, the lender requests full detailed information about the project like –
- Building Plans and Specifications
- General Contractor’s Bids
- Cost Projections
- Construction Timelines
- Documents of Local, State, and Federal Approvals
- Pre-Leasing Information
- 3-year Financial History of Personal and Company Tax Returns
- Financial Appraisal Analysis
- Other Financial Statements like Profit and Loss Statements, Bank Statements, Balance Sheets, etc.
- Site-Environmental Testing
As a commercial construction loan has no operating history to underwrite, the valuation of the property is only based on the real estate pro forma. Due to the extra risks involved, the project team, general contractor, and market conditions are all examined in more depth.
After the construction loan has been approved, the lender will provide a ‘commitment letter’ which is a legally binding contract.
Step 4 – Loan Approval and Closing
Once your loan application has been approved, the lender will provide you with a closing checklist mentioning requirements to be fulfilled before the loan closing and funding starts. The entire construction loan application process, right from the initial request to underwriting to approval and eventually closing, takes about 30 days on average.
Finally, you and the lender will create a draw schedule for disbursing partial funds for the costs incurred in each stage of the construction.
Step 5 – Draw Schedules and Fund Disbursement
Once the funding is approved, you will create a draw schedule which the lender will translate into a standard draw schedule template. This template will form the schedule for when the lender will incrementally disburse funds to you. Finally, the construction loan lender or a third-party inspector will inspect that the requested work funded by that specific draw has been finished.
Step 6 – Apply for a Permanent Loan
After completing the project, loans called ‘construction-perm’ or ‘construction-to-permanent loans’ will automatically convert into a traditional mortgage loan. As a result, these loans can save a lot of time, paperwork, documentation, and closing costs.
An advantage of construction-to-permanent loans for small business owners is that instead of borrowing a loan for the construction and then another for financing the finished project, you can get two loans at once. Therefore, you only close once and pay one set of closing costs.
If you are interested, discuss with your financial institution about permanent construction financing options before the project is completed.
How to Select the Best Commercial Construction Loan? – 5 Tips
As a construction project owner, you must consider different factors while selecting the right type of loan. Here are effective tips on choosing the best commercial construction loan for your venture.
1. Decide What You Want
Firstly, determine what’s the purpose of securing the loan. Is it for financing the entire construction project or only for acquiring land? Are you going to build new or remodel an existing space? Be clear if you are interested in receiving a short-term or long-term loan.
2. Compare Interest Rates and Terms
One of the most essential factors to compare while shopping for a construction loan is the interest rate among different lenders. For example, lender A offers an interest rate of 4.5%, while Lender B provides an interest rate of 5.2%. Opting for Lender A may save on interest, but it requires a higher credit score for approval. Besides, interest rates, compare the length of the loan, down payments, prepayment penalties, and other terms.
3. Enquire About Fees and Charges
When selecting a construction loan for your commercial real estate, enquire about the fees associated with it. These fees can include origination fees, appraisal fees or charges like loan closing costs or annual insurance premiums. Be upfront to ask about any fees so there are no misunderstandings later.
4. Provide Detailed Information About Your Construction Project
This is an important step for securing the best possible deal. When applying for a commercial construction loan, provide every detail about your business and building project. Information such as financial statements, tax returns, and bank statements will give lenders a better insight into your financial history and convince them to lend to you.
5. Openly Negotiate With Your Lender
If you are not comfortable with the loan’s interest rate or repayment terms, don’t hesitate to ask for a better deal. Take a strategic approach when requesting adjustments to the loan terms through negotiations. This will ensure the selected construction loan meets your financial requirements.
Hence, comparing different loan lenders and encouraging an honest negotiation will get the best construction loan for your project.
Case Study – Financing Office Building Construction
A California-based commercial real estate investor pursued the construction of a small office building valued at $2 million. For this project, they opted for a government-backed SBA 7(a) Loan. The lending bank structured a flexible 15-month construction loan at 80% Loan-To-Cost. This helped kickstart the construction project.
To fund the remaining amount, the investor secured a Mini Perm Loan, with the understanding that it would be replaced by long-term financing once the finished project generates revenue. This strategic financing approach ensured smooth funding and development of the project.
Alternative Construction Financing Solutions
Alternative commercial construction financing entails a broad range of sources from where businesses can borrow money and meet their cash flow requirements. Following are some of the viable alternatives to a commercial construction loan.
Shares
Shares represent equity in a corporation. Equity can be utilized to cast vote on company decisions and enjoy rights and privileges as a shareholder. They offer individuals or groups major ownership of a company. Investing in shares can be a viable financing option for those who have a high-risk tolerance and are willing to lock in their money in company stocks to earn substantial returns.
Debentures
Debentures are loans lent to a company in return for a share of its profits at a fixed interest rate. Unlike conventional construction loans, debentures lack collateral and usually rely on the firm’s reputation that issued them. This type of construction financing works well for entrepreneurs looking to avoid the issuance of shares and dilution of their equity. They are also recommended for companies who don’t want to risk their assets or lack collateral for a traditional loan.
Merchant Cash Advances
A merchant cash advance (MCA) gives quick access to a lump sum of money in exchange for a percentage of future credit and/or debit card sales. This construction financing alternative is advantageous for small to mid-sized business owners as it provides fast approvals, funding within 2 days, and needs minimal documentation. A bad credit score won’t lessen an issuer’s chances of loan approval.
Equipment Loans
As the name suggests, equipment loans are exclusively for financing construction equipment purchases. Assets such as vehicles, office electronics, medical equipment, and construction machines serve as collateral. Business owners need lower credit ratings to qualify for these loans. Specialty loan companies as well as SBA and banks can also grant you an equipment loan.
Conclusion
As a business owner, the vision of acquiring new land for your company, developing and constructing a commercial building on it, or renovating your existing facility fills you with hope. Obtaining commercial construction loans doesn’t have to be stressful if you understand different types of loans and their requirements. One tip is to be prepared ahead of time and approach your construction loan lender with confidence and conviction. Then, you will surely pass the lending process with ease.
FAQs
What is the minimum % of down payment lenders ask for a commercial real estate loan?
Most commercial business loans require 25% of the total project costs as a down payment. However, for mezzanine loans, the down payment is 15% and for SBA financing, it is as low as 10%.
How long do commercial building loans last?
Most commercial real estate loans last up to 10 years, however, loan amortizations can be up to 25 years. The borrower has to pay a fixed or varying commercial construction loan interest rate at a specified percentage above the prime rate.
How do commercial construction loans differ from residential loans?
Commercial loans have a higher rate of interest, lower loan-to-value ratio (LTV), and shorter terms than residential loans.
Relevant Resources:
How Do I Choose a Good General Contractor?
Land Development and Permitting: Get the Facts Before Your Project Starts
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