What it is
A construction loan finances ground-up development or a major redevelopment. Unlike most loans, it doesn't fund all at once. The lender advances money in stages, called draws, as construction progresses and costs are verified. The borrower's equity typically goes in first.
Once the building is complete and leased, the construction loan is repaid, usually with a permanent loan or sometimes a bridge loan during lease-up. Some lenders offer construction-to-permanent loans that convert in one step.
How it commonly works
- Leverage on cost. Sized mainly on loan-to-cost, with a check against projected stabilized value. Maximum LTC varies by lender, asset class and sponsor.
- Equity first. The sponsor funds its share of the budget before the lender's first draw.
- Draws. The borrower submits draw requests, typically monthly. An inspector verifies work in place before the lender funds.
- Interest reserve. Since the building produces no income during construction, interest is often paid from a reserve built into the loan budget.
- Floating rate and short term. Commonly priced over SOFR with a term matched to construction plus lease-up.
- Guarantees. Construction lenders usually require a completion guarantee and some level of recourse during construction.
Example budget
| Line | Amount |
|---|---|
| Land | $4,000,000 |
| Hard costs (incl. contingency) | $12,500,000 |
| Soft costs | $2,500,000 |
| Interest reserve and financing costs | $1,000,000 |
| Total cost | $20,000,000 |
| Construction loan (65% LTC) | $13,000,000 |
| Sponsor equity | $7,000,000 |
The figures are illustrative.
What lenders need to see
- Full budget with hard cost contingency, and a general contractor's bid or contract
- Plans, permits or a clear permitting path, and zoning
- Construction schedule and lease-up assumptions
- Market study and rent or sale comps for the completed product
- Sponsor development track record and financial strength
- A stabilized pro forma and the takeout financing logic
Common mistakes
- Thin contingency. Cost overruns are common. Lenders expect a cushion.
- Unpermitted projects pitched as shovel-ready. Lenders will ask.
- No takeout math. If the completed building's NOI won't support a permanent loan large enough to repay the construction loan, the lender sees the problem immediately.
- First-time developer, big project. Pair with an experienced partner or a smaller first deal.
In the package
Lead with the sources and uses, the budget and the capital stack. Then show the completed-project economics and the sponsor's construction experience. The loan package guide covers the rest.