How Do Commercial Construction Loans Work?
Unlike a standard loan that provides funds in a single payout, a commercial construction loan is paid out in stages, known as “draws.” These draws are aligned with a pre-approved construction schedule and budget. As the project reaches specific milestones—such as laying the foundation, framing the structure, or installing plumbing—the lender inspects the work. Upon verification, the lender releases the funds needed to pay for that stage of the project.
Key features of this financing include:
- Short-Term Financing: Loan terms typically range from one to three years, covering only the construction phase.
- Interest-Only Payments: Borrowers often pay only the interest on the funds that have been drawn, which helps manage cash flow before the property generates income. The business loan interest rate is often variable and tied to a benchmark like the prime rate.
- Loan-to-Cost (LTC) Ratio: Lenders rarely finance 100% of a project. They usually cover 70-85% of the total cost, requiring the borrower to contribute the remaining 15-30% as equity.
- Take-Out Loan: Once construction is complete, the construction loan must be paid off. This is typically done by refinancing into a permanent, long-term commercial real estate loan, also known as a “take-out” loan.
What Are the Requirements to Qualify?
Lenders view commercial construction loans as high-risk because the asset being financed does not yet exist. To mitigate this risk, they have strict qualification criteria. A strong business loan application will demonstrate:
- Developer Experience: A proven track record of successfully completing similar construction projects.
- Strong Financials: Excellent personal and business credit, a healthy balance sheet, and sufficient cash reserves.
- Detailed Project Plans: Comprehensive architectural drawings, a line-item budget, a realistic construction timeline, and all necessary permits.
- Significant Equity Contribution: The ability to fund a substantial portion (at least 15-30%) of the project costs.
- Viable Exit Strategy: A clear plan for how the loan will be repaid, which usually involves securing a commitment for a permanent mortgage.
- Collateral: The property itself serves as the primary business loan collateral. Lenders may also require personal guarantees from the business owners.
Commercial Construction Loan vs. Commercial Mortgage
While both loans finance commercial property, they serve different purposes and have distinct structures.
| Feature | Commercial Construction Loan | Traditional Commercial Mortgage |
|---|---|---|
| Purpose | Funds new construction or major renovations | Purchases or refinances a completed, existing property |
| Term | Short-term (1-3 years) | Long-term (5-25+ years) |
| Funding | Disbursed in stages (“draws”) | Disbursed as a lump sum at closing |
| Payments | Typically interest-only | Principal and interest payments |
| Lender Risk | High | Lower |
Frequently Asked Questions (FAQs)
Q: Can I use a commercial construction loan for a major renovation?
A: Yes, these loans are suitable for substantial renovations that significantly alter or add value to a property, such as a complete interior overhaul or a major structural addition. They are not intended for minor cosmetic updates.
Q: What happens if construction costs exceed the budget?
A: Cost overruns require the borrower to cover the shortfall, either by injecting more personal equity or securing additional financing. This is why lenders insist on a contingency fund (typically 10-15% of the budget) from the outset.
Q: What is a “draw schedule”?
A: A draw schedule is the detailed timetable of construction milestones and corresponding fund disbursements. It is agreed upon by the borrower and lender before the loan is finalized and dictates the flow of money throughout the project. For more detailed information on lending practices, the Office of the Comptroller of the Currency (OCC) provides a comprehensive Commercial Real Estate Lending handbook.