You've reached a point in your business where you're ready to grow. Perhaps you're renting office space and thought it's the right time to construct your own office space. Maybe your home has grown too big and would like to add to your area. Your situation could be entirely different: you're an aspiring company just beginning to get off the ground and want to build your home from scratch.
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Whatever the situation, most businesses are in the case that the construction of a new property or improvement is the following step to business expansion. Naturally, that expansion comes with the cost of a large amount and most businesses aren't able to take on upfront. This is the moment to consider the possibility of obtaining a commercial construction loan.
Similar to other types of loans, it's essential to be aware of the principles behind commercial construction loans. Find out the basics about the commercial loan, the times you should consider applying for one, and what you can anticipate during the application process.
WHAT IS A COMMERCIAL CONSTRUCTION LOAN?
Commercial construction loans are one type of loan used to pay for the expenses associated with building or remodeling commercial buildings. The money from construction loans can be used to finance the labor and other materials needed to create a new building, acquire or develop land to construct an upcoming commercial property, or renovate existing properties.
WHY TAKE OUT A COMMERCIAL CONSTRUCTION LOAN?
Businesses that intend to buy commercial properties may be eligible for a loan, also known as a commercial mortgage. However, if you want to remodel your current space or build a new structure from scratch, it is necessary to obtain commercial construction loans.
Renovations and new construction are costly Imagine hundreds of thousands or thousands of dollars. Most growing businesses don't have the funds in their bank, so instead, they seek commercial construction loans. Commercial construction loan lenders will provide you with money throughout the construction process to cover the cost of labor, equipment, and materials, as well as the development of land so that you don't need to cover the expenses yourself.
HOW COMMERCIAL CONSTRUCTION LOANS WORK
Commercial construction loans are distinct from other types of loans. They are typically structured so the borrower can receive the entire loan in one lump amount. When the loan is accepted, the borrower must repay the loan via scheduled payments over a specific time. Commercial mortgages usually include a monthly repayment plan lasting 10 years or more.
Commercial construction loans mean that the total sum of the loan will not be given at the beginning. Instead, the borrower collaborates with the lender on the draw schedule. This means that a portion owed will be released once the project reaches new milestones. For instance, the first draw will cover the development and clearing of the land. The next draw will be released when the foundation has been laid. A second draw is released after the building has been constructed.
Once each milestone has been completed, lenders generally need an inspector to verify the work is done before releasing each draw. This process will continue until all milestones are achieved, and the entire value of the loan has been disbursed.
If you take out commercial construction loans, you will only pay interest on the part of the loan's profits that have been received. If the total amount of your new building is $500,000 and the lender only releases $100,000, you'll pay interest on the $100,000.
Typically, a construction loan is structured in such a way that the borrower only pays the interest once the loan is fully released. The borrower can then pay the principal by one sum in completion of the construction.
However, what can the borrower do once the project is completed and the entire sum of the loan has been paid? Instead of making one colossal installment, the borrower can obtain a commercial mortgage. The property will act as collateral, and the borrower will utilize the money derived from commercial loans to repay the construction loan for commercial purposes. The new mortgage will mean that the lender will be bound to smaller monthly payments that are more affordable over extended periods.
Other loans for construction projects in the commercial sector, such as that of the Small Business Administration CDC/504 loans, offer longer-term options. Therefore a further loan after the completion of the project is not required.
INTEREST RATES
In the case of commercial loans for construction, the borrowers should be prepared to pay interest rates that range between 4 to 12%. The borrowers with the highest credit scores will pay the least interest rates. The kind of lender you deal with can also be a factor. A commercial construction loan offered by the bank usually has the lowest interest rates; however, those who make loans with hard cash charge higher interest rates on their loans.
FEES
A variety of charges could be incurred when you take out commercial construction loans. The fees and the amount differ by the lender. The prices you might be required to cover for this kind of loan are:
- Guarantee Fees
- Processing Fees
- Documentation Fees
- Project Review Fees
- Fees for Fund Control
DOWN PAYMENT
Since commercial construction loans are high risk, so the requirement for a deposit is necessary. When a down payment is made, the borrower takes some dangers off the loaner. The typical down payment requirements are 10-30 percent of the total project cost. Rarely will lenders be able to provide all the expenses of commercial construction projects.
Conventional lenders make use of a method called "loan-to-cost" in the case of commercial construction loans. The loan-to-cost ratio is calculated by dividing the total loan value by the project's total cost. For instance, a company is seeking an amount of $190,000 to finance an undertaking with a total expense of $200,000. The loan-to-cost for this scenario will be 95 95%.
While requirements vary from lender to bank, most lenders require a cost-to-loan of between 80% and 85%. In the case of the previous example, the lender could loan $60,000 at 80% and $170,000 at 85 percent.
If this happens, then what should the borrower take action? Although they might be required to pay the rest of the costs out of pocket, there's another option -mezzanine loans. A mezzanine loan that we'll talk about a bit later.
BORROWER REQUIREMENTS: HOW COMMERCIAL LENDERS EVALUATE ELIGIBILITY
Not all construction projects qualify for commercial construction loans. There are many factors the lender must take into consideration when determining eligibility.
The first aspect that lenders will look at is the credit rating. Since these loans are considered high-risk, the lenders will want to work with those with low risk and high credit scores. While credit requirements can vary from lender to lender, you need to have an average credit score at the very least in the 600s before you can apply for loans like those offered by the SBA CDC/504 loans. Some lenders might require a minimum credit score of the 700s. Corporate credit scores are also examined.
The lender may also look at your debt-to-income ratio, also called DTI. The ratio shows your income and the business's debt annually. Typically, lenders want an income to debt ratio that is less than 43 however, some lenders might have more stringent requirements. The less your DTI is, the better your chance of getting approval. To determine your DTI follow the formula below:
Total Monthly Debt Payments / Gross Monthly Income = DTI
Find out more about how you can determine and reduce your DTI prior to applying for the loan.
Also, lenders will consider their debt-service coverage ratio or DSCR. This is a way to show the relationship between the amount of income and the amount of debt for your company on a year-round basis. To figure out your figures, you can use these formulas:
Net Operating Income / Current Annual Debt Obligations = DSCR
The DSCR differs from DTI since you would like the number to be higher. This indicates that your business has enough revenue to pay off the cost of new loans. The majority of lenders require a DSCR of 1.25 or greater. However, there are different requirements for each lender. Find out more about how to calculate the DSCR.
A lender may also consider your experience in the industry and the financials of your business to determine if you are eligible for a loan. You'll have to submit comprehensive plans for construction to be approved before the loan is granted. In some instances, programs might require modification in response to any risk identified by the lender, therefore the ability to be flexible with your plans is crucial.
TYPES OF COMMERCIAL CONSTRUCTION LOANS
If you've learned more about commercial construction loans It's time to look into the various types of loans available.
SBA CDC/504 LOAN PROGRAM
The Small Business Administration (SBA) 504 loan is among the most sought-after business construction loan. This is due to the fact that these loans offer low monthly payments and competitive interest rates as well as credit scores of the 600s.
Borrowing Amount | No maximum, but the SBA will only fund up to $5 million |
Term Lengths | 10 or 20 years |
Interest Rates | Fixed rate based on US Treasury rates |
Borrowing Fees | |
Personal Guarantee | Guarantee required from anybody who owns at least 20% of the business |
Collateral | Collateral required; usually the real estate/equipment financed |
Down Payment | 10% - 30% |
Through this loan, the SBA-approved Certified Development Company will fund 40% of the expenses to refurbish existing facilities, construct the new facility, or buy/improve the land. A maximum of $5 million is readily available to those who are borrowers.
Another lender must pay 50% of the project's costs, while the borrower will be accountable for the remainder of 10 percent. In certain instances, the borrower might be required to pay 20% of the cost. The repayment terms are offered for up to 20 years and the interest rates are determined by the prices of the market forU.S. Treasury issues.
SBA 7(A) LOAN PROGRAM
The SBA also offers the 7(a) program, which is utilized to purchase and construct commercial real property.
With the program, loanees could get the sum of $5,000,000 in repayment terms of up to 25 years. The interest rates are based upon the rate of interest at which they are prime, plus the maximum rate of 2.75 percent. To be eligible, applicants must have a credit score in the upper 600s and a down payment of 10 percent to 20 percent.
Here are the rate and the markups that apply to a 7(a) loan with the SBA:
| Loan Amount | Less Than Seven Years | More Than 7 Years |
|---|---|---|
Up to $25,000 | Base rate + 4.25% | Base rate + 4.75% |
$25,000-$50,000 | Base rate + 3.25% | Base rate + 3.75% |
$50,000 or more | Base rate + 2.25% | Base rate + 2.75% |
Are you considering getting the SBA 7(a) loan? Take a look at SmartBiz, one of our preferred mediators of SBA loans:
BANK LOANS
A conventional commercial construction loan from a bank is a different alternative that business entrepreneurs can consider. The rates, repayment terms, and down payment requirements differ. In general, a minimum down amount of 10% will be needed, maximum terms for repayment of 25 years are standard, and variable and fixed rates are offered. You can begin your search for a lender by discussing the financing requirements with your current bank. Check out our article on the most suitable bank loans for small-sized businesses should you be interested in specific suggestions.
MEZZANINE LOANS
In the previous post, we discussed the ratio of loan-to-cost. If the percentage of loan-to-cost is less and the borrower has to find additional funds, then a mezzanine loan could be a viable alternative. Stocks secure the mezzanine loan. If the borrower fails to repay, then the lender can convert it into an equity stake. With a mezzanine credit, the borrower is more powerful and can attain a loan-to-cost ratio as high as 95 percent.
WHERE TO FIND COMMERCIAL CONSTRUCTION LOANS
You're aware of the various types of loans available, but where do you locate the right lender? The answer is dependent on the kind of loan you're looking for.
An SBA-approved intermediary lending institution (credit unions, banks, and private lending) provides 7(a) loans. For loans CDC/504, the SBA-approved non-profit CDC can provide this loan. However, you'll need a different lender to provide 50 percent of the project's costs.
The banks, as well as credit unions, provide a wide range of types of commercial loans for construction, such as SBA loans, conventional loans, traditional loans, and mezzanine loans.
Additionally, commercial construction loans can be secured through hard-money lenders. They are private money lenders who provide short-term financing alternatives for construction jobs in the commercial. While there are several advantages to using these loans, such as low upfront costs and speedy approval, they typically are accompanied by higher interest rates and fees than those offered by other lenders.
HOW TO APPLY FOR A COMMERCIAL CONSTRUCTION LOAN
If you've found an appropriate commercial construction loan, The following step will be to start the application procedure. In this application, the lender will look at your business and personal financials, your credit score, and other aspects that determine if you're approved and what your rates of interest and repayment conditions will be.
Since construction loans are deemed high-risk, it is essential to present the lender with an extensive business plan. It should comprise an overview of your company's activities, its financials for the last year, and details of your current operations and procedures.
Additionally, you will need to give your lender specifics about the project. This should include a detailed design and specification. A projected project cost with estimates for materials, contractors, and other costs must be submitted along with the application.
Your application must also provide financial documents for business and personal use. This includes, but is not included in the tax forms for both companies and individuals, Profit and loss statements as well as balance sheets, income statements, bank statements, and schedules of debt that show the current obligations to repay debt. The requirements for documentation will differ depending on the lender.
The lender will check your credit score as part of the process. Keep in mind that lenders will be looking for scores in the upper 600s. For some lenders, destructive items like bankruptcy or foreclosures and past defaults on loans could be a reason to deny you loans. If you have negative information on your credit reports, explaining the situation to your lender might be required.
Since this is a hazardous loan product, the lenders typically need at least several weeks to review the information you provide. During this time, additional documents could be required or the lender might have questions, so be sure that you're available to help speed the procedure.
After the lender has underwritten and approved your loan, you'll begin the closing procedure. This involves reviewing the loan contract, which includes the dates and milestones covered throughout the process. After all, the documents have been completed and the closing process is completed, you'll be ready to start the expansion of your company.
COMMERCIAL CONSTRUCTION LOAN FAQS
What are commercial construction loans? How do they function?
Commercial construction loans are based on a "draw schedule" where the funds are not disbursed at once however, they are disbursed whenever milestones agreed upon are reached. When each milestone is met, lenders will generally inspect to ensure that the criteria for the milestone are completed. Construction companies pay interest only on the sum the lending institution has given them as of the date. If your new construction project costs one million dollars, and the lender has released only $200,000, you'll be charged the interest on only $200,000.
What are the rates and terms I find for a commercial construction loan?
Most commercial construction loans come with rates of interest ranging from 4 and 12 percent. The higher your credit rating, the higher rates you'll get. In addition, banks typically have lower rates than alternative or hard money lenders. Most lenders will require a deposit of between 10 10% to 30%. Conventional lenders make use of a method called the loan-to-cost ratio in commercial loan construction. The loan-to-cost ratio is calculated by dividing the loan sum by the project's total cost. The majority of loans require a ratio of between 80 and 85 percent. The repayment length varies depending on the loan and lender but generally ranges from 5 to 25 years.
Which businesses can be suitable for commercial construction loans?
The two primary aspects required for commercial construction loans are your credit score and the debt-to-income ratio. Typically, lenders will look for a debt-to-income balance of less than 43%, but specific lenders might have more stringent standards. The smaller your DTI will be, the better your chances of getting approval.
How difficult is it to secure a construction loan for commercial purposes?
It's possible to be a challenge to get a loan due to reasons that are beyond your control. When your credit rating and debt-to-income ratio are low, you'll struggle to get commercial construction loans. Another consideration is whether the lender anticipates an excellent return on their investment. This will depend on the business that you're building for, as well as general economic trends.
Where is the most suitable place to obtain a construction loan for commercial purposes?
The most suitable place to look for commercial construction loans will be one that gives you the most favorable terms you can get in line with your borrower's profile. For businesses with excellent ratings on credit and ratios of debt-to-income that are in good shape, a bank loan is probably the most suitable option, precisely one that invests in the development of the area you're in. If you don't meet these criteria, you might be interested in other lenders that provide commercial construction loans or the hard-money lenders if your venture matches their requirements.
FINAL THOUGHTS
It's always exciting to get to an era in your company where you're ready to grow; However, getting the funding you need could be a problem. If you're planning on constructing new facilities or upgrading the current structure, getting commercial construction loans doesn't have to be complicated.
If you know the various kinds of loans and the requirements and have done some preparation work before you need it, then you'll be able to confidently contact your lender and navigate the lending procedure with ease.
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