Home Construction Loan
Under a home construction loan, also called an interim loan, money is advanced as new home construction takes place. For example, a construction loan for land or
a vacant lot, the owner arranges to borrow $60,000 to build a house. The lender does not advance all $60,000 at once because the value of the collateral is insufficient to warrant that amount until the house is finished. Instead, the lender will parcel out the loan as the building is being constructed, always holding a portion until the property is ready for occupancy, or in some cases actually occupied. Some lenders specialize only in construction loans and do not want to wait 20 or 30 years to be repaid. If so, it will be necessary to obtain a permanent long-term mortgage from another source for the purpose of repaying the home construction loan. This is known as a permanent commitment or a take-out loan, since it takes the construction lender out of the financial picture when construction is completed and allows him to recycle his money into new construction projects.
Construction Loan Project Financing FAQ
How can development projects be differentiated from one another in the
marketplace?
Developers can try to differentiate themselves in many ways including the type
of property that they develop (e.g., various classifications of use,
construction quality, space quality, and tenant type.)
What is the process of financing the construction and operation of a typical real estate development.
In general, developers must first line up permanent (long-term) financing that will be used once the project is complete and being operated with tenants before they can get a home construction loan. It is necessary that the home construction loan
is repaid when the permanent loan takes over.
What are the sources of risk associated with project development?
Sources of risk associated with project development include market risks and
project risks. Market risks are the result of unexpected changes in general
market conditions affecting the supply and demand for space. Project risks are
the result of choosing a specific location to develop a property and the design
of the project.
What are some development strategies that many developers follow? Why do they
follow such strategies?
Business strategies used by developers can be categorized in three general
ways:
- Owning and managing projects for many years
- Selling projects after the lease-up phase
- Developing land and buildings for lease in a master-planned development or
“build to suite” for single tenants.
Following a particular strategy allows the developer to have a balance
between use of external contractors, architects, real estate brokers, leasing
agents, and property managers and having this expertise within the firm.
What is a spec or open-ended home construction loan? When is such a loan likely to be used?
A spec or open-ended home construction loan is one that is made to a developer who has not obtained a permanent loan commitment. Generally, this kind of loan is made when market demand is relatively strong and it is highly likely that after the project is leased-up the developer will either be able to obtain permanent financing or be able to sell the project to repay the home construction loan.
What contingencies are commonly found in permanent or take-out loan commitments? Why are they used? What happens if they are not met by the developer?
Contingencies commonly found in permanent or take-out loan commitments include:
- A maximum amount of time to obtain a home construction loan commitment
- A date for completion of construction
- Minimum rent-up (leasing) requirements and an approval of major leases
- An expiration date of the permanent loan commitment and any provisions for
extensions
- An approval by the permanent lender of design changes and substitution of any building materials.
What is a standby commitment? When and why is it used?
A standby commitment is an agreement by a lender to provide permanent financing for a property once construction is complete. It is used by a developer to obtain construction financing, because construction lenders typically require the commitment of a permanent lender before a home construction loan
will be made. The
permanent lender may receive a fee for making the commitment to provide permanent financing, if necessary. A standby commitment is often used by developers who are still shopping for permanent financing, but need a commitment in order to obtain the home construction loan. Thus, the standby commitment is like an option that the developer can use as a source of financing, but may choose not to if a better alternative is found.
What is a mini-perm or bullet loan? When and why is this loan used?
A mini-perm or bullet loan is a home construction loan that, in effect, becomes permanent financing when construction is complete. When construction is complete, the developer begins to make payments (principal and interest) similar to those made on permanent financing with the exception that the loan typically has a 3 to 5 year maturity with the balance (balloon payment) due at that time.
Third-party lenders sometimes provide gap financing for project developments. Why is this lending used? How does it work?
Gap financing is necessary when a home construction loan is not sufficient to cover the developer’s needs until the project is complete and the permanent loan is available. It is available from lenders who expect to be repaid from proceeds of the permanent loan.
A presale agreement is said to be equivalent to a take-out commitment. What will the construction lender be concerned about if the developer plans to use such an agreement in lieu of a take-out?
A presale agreement differs from a take-out commitment in that proceeds from the sale of a property are used to repay the home construction loan
rather than the permanent loan. The construction lender must be sure that the agreement requires the buyer to purchase the property at an amount that is sufficient enough to pay off the home construction loan
and that there will be no contingencies in the agreement that allow the purchaser to cancel the agreement.
What do is meant by overage in a retail lease agreement? How might it be calculated?
Retail leases often specify a minimum rent that must be paid by tenants, as well as a percentage rent provision whereby the tenant pays rent based on a percentage of sales revenue once sales revenue exceeds a specified minimum amount. The amount by which the total rent exceeds the minimum rent is referred to as overage rent.
Why is the practice of “holdbacks” used? Who is involved in this practice? How does it affect construction lending?
Holdbacks are used by construction lenders to be sure that a developer has met all of his or her obligations before all of the funds from the home construction loan
are given to the developer.
Why don’t permanent lenders usually provide construction loans to developers? Do construction lenders ever provide permanent loans to developers?
Permanent lenders are often national companies, such as large insurance companies, that do not have the in-house capability of underwriting construction loans and monitoring a project during construction. Thus, home construction loans are typically made by lenders, such as commercial banks with a local presence. Construction lenders, on the other hand, may be willing to make a permanent loan, although they may find it more profitable to focus on home construction loans or mini-perms.
What is the difference between the assignment of a take-out commitment to the construction lender and a triparty agreement? If neither device is used in project financing, what is the relationship between lenders in such a case?
The triparty buy-sell agreement goes beyond the assignment of the take-out commitment and provides that the permanent lender will notify the interim lender that the take-out commitment is in full effect, that the permanent lender will indicate whether all necessary plans and documents have been reviewed and approved prior to closing the home construction loan, and that the permanent lender will provide the construction lender with notice of any violations in the terms of the loan commitment by the developer and the time available to cure such a violation. In the absence of either assignment of the take-out commitment or a triparty buy-sell agreement, the construction lender has no way to force the developer to close on the permanent loan and repay the construction loan.
What is the major concern construction lenders express about the income approach to estimating value? Why do they prefer to use the cost approach when possible? In the latter case, if the developer has owned the land for five years prior to development would the cost approach be more effective? Why or why not?
The income approach usually provides a good indication of the expected value of an income-producing property once construction is complete and it has been leased-up. The projected value should exceed construction costs, if this is not the case, the project is not feasible and the loan should not be made. Assuming that the project
is feasible, using the cost approach would provide a more conservative estimate of value, especially if the land has appreciated in value from its original cost to the developer.
Home Construction Loan to Home Loan
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