Construction Lending Basics
Construction loans, unlike conventional loans, have two main functions; first, to fund construction costs in a manner that facilitates lien-free completion of the project, and second, to ensure the lender’s ability to complete construction if for any reason the borrower is unable to complete the project. Thus, the focus of the construction loan quickly becomes the lender’s need to minimize risk.
As such, the modern trend has become a lending situation somewhat unique to construction loans. Lenders will often refuse to lend the full amount necessary for a borrower to complete the totality of the project. Instead, lenders will require either some equity from the borrower similar to a conventional loan, or require a second lender often referred to as a “gap” lender. However, a lender’s reduction of risk does not end there.
Given the inherent risk in construction projects, most lenders will require some due diligence prior to extending a loan to the borrower. At minimum a lender will typically require an estimated budget that includes itemized costs from the actual purchasing of the land to final completion. But, in practice most lenders will require proposed contracts, architectural/engineering drawings, environmental studies/assessments, zoning/permitting requirements, utilities, and the list goes on. Further, the risk of such a loan will in all likelihood require some insuring/bonding agreement, generally referred to as a performance bond. Likewise, in an effort to ensure that the lender is the priority lien holder, the lender may request a pre-inspection of the property to confirm that no improvements have been completed/begun. These are all in excess of the standard closing documents typically found in the underlying real estate transaction to purchase the real property.
The Construction Loan in Practice
Once the loan is extended to the borrower, the borrower will need to follow certain funding procedures. In most cases the borrower will need to submit draw requests, typically accompanied by a lien waiver, in order to receive the actual funding. These requests generally include some verifiable statement from the general contractor and/or the architect stating that the work has been completed on the project and to what extent the funding has or will be applied.
This process continues until the final draw request is necessary. Once the borrower makes the request for the final draw, the lender will then require a final inspection of the project along with all necessary lien releases and statements of completion.
That said, in most circumstances this phase of the construction loan is anything but typical. Issues such as change orders, delays in the construction timeline, subcontractor issues, rising construction costs, and so on, greatly alter how this portion of the construction loan will proceed.
Construction loans tend to consist of much higher interest rates than conventional loans. Accordingly, once the project is complete the borrower should transfer/convert their construction/gap loans to a permanent conventional loan. The permanent lender will then forward the funds to the construction lender who will in turn issue a release of lien on the construction property thus completing the construction lending process.
In all, construction lending is vital to the continued development of our region but requires a careful detailed analysis to properly protect both the lender(s) and the borrower(s). This is an extremely basic overview of the construction lending process as most construction loans require a great deal more in terms of due diligence, assurances to the lender, and general oversight of the project. For these reasons, this article is not meant to substitute the advice of an attorney. Should you have any questions regarding construction law, please contact our offices.