Unique Considerations in Construction Loans

Banker Resource
April 8, 2013 — 1,692 views  
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Constructing a building can be the most interesting or the most challenging project in someone’s life. Irrespective of the fact that it is for dwelling or commercial purposes, it is almost impossible to go about it without a strong financial support. Banks provide construction loans in order to build a new building and not for the purpose of redecoration and renovation.

The loans are structured in two ways, having two different closings. The loan is short-term financing which primarily covers the cost of land acquisition, and then building construction, sanctioned as needed, when each stage is completed. This is usually at a much higher interest rate than in the market. Upon the completion of the project, the loan is refinanced to a more market-based rate.

Most Common Types of Construction Loans

Construction loans options can vary according to varying interest of the loan provider as well as the client. It is therefore necessary for the bank professional to review meticulously, the specific requirements of the client, while keeping in mind the maximum profit for the firm before suggesting a loan option. Here are a few common types of construction loan options that can be considered by a bank professional.

  • Land Development Loan: When an underdeveloped land has to be made fit for construction, such a loan can be considered.
  • Acquisition & Development Loan: For the development of land, which is not exactly a raw land but one, which will still require some modifications in order to be fit for construction.
  • Mini Perm Loan: It can be provided if the land in view, after construction has profit making potential. So, after a few years of generating income this temporary loan is reconstructed into a long-term financing.
  • Takeout Loan: It is essentially the long-tem financing loan which comes into the picture where the short-term construction loan is already present. It takes care of the entire financing of the project post land development and building construction.
  • Interim Construction Loan: It takes care of the labor charges and construction material costs. It is settled once the building project is complete and the mortgage is in place.

Risks Associated with Writing a Construction Loan

From the point of view of a banker, construction loans are one of the most risky loans to grant. Commercial construction loans are driven towards generating financial benefits from the project once completed. In the case when the project, even after completion fails to generate the desired revenue, the losses incurred are huge. From the banker’s perspective the risk of failure of a commercial construction loan can happen in so many different levels

  • Construction Failure: The inability of the contractor to finish the project on time or in budget.
  • Market Risk: There is always a probability factor associated with the commercial success or failure of the project building itself.
  • Commercial Constraints: The financing of the project primarily depends on pre-project assumptions. Completion of a project can typically take more than a year’s extra time. In such a scenario, some investors must be willing to give the extra time and finance for the completion of the project. An adverse economic state can adversely impact the project. In such a case, switching to permanent financing is often not possible.

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