Why Are Construction Loans Inherently Risky?

For commercial real estate investors and property developers, securing financing for a construction project can be extremely challenging. Most lenders consider construction loans to be inherently risky for a number of reasons, which we will examine.

Unpredictable Markets and Politics

Many lenders are gun shy about providing construction loans because they do not like uncertainties, and construction projects are full of unknown variables. For the most part, lenders like to steer clear of anything related to commercial real estate and development. Due to previous lending practices that ramped up right before a market crash, lenders have a history of not seeing returns on their loans. Then there are political moves, which can completely halt construction projects. On more than one occasion, lenders have provided construction loans and permanent financing, only to have government officials move to stop construction before it even starts. These two factors alone have made lenders take the stance that construction loans are risky.

Overruns and Accidents

Both developers and lenders want to keep construction projects safe and efficient in order to reach completion and start generating revenue. However, multiple change orders can lead to budgetary overruns and delays. Additionally, large construction projects require insurance, because accidents can happen when people and machines work together for any period of time. Both overruns and the potential for accidents on the job pose big risks in the eyes of lenders.

Experience Goes a Long Way

No matter how potentially lucrative the deal, lenders are hesitant to approve construction loans unless at least one person on the project has prior experience in construction and an equity stake in the project. This acts as a reassurance that the lender is approving financing for a project where people know what they are doing, and can manage the project as well as the financial obligations involved.

Understanding Ratios for Construction Loans

Lenders use a number of financial ratios to determine the amount of financing they can offer on construction loans. The first is the loan-to-cost ratio (LTC) which is simply the amount of the loan divided by the total cost allotted for the project. LTC ratios typically hover around 80%, where the borrower provides 20% of the total cost. The debt service coverage ratio is based on the Net Operating Income (NOI) of the property after construction finishes and the property is leased, divided by the annual debt service on the proposed takeout loan. A takeout loan is simply permanent financing used to repay a construction loan. The loan-to-value (LTV) ratio is calculated by the value of the property after construction and leasing. LTV is usually 70% and provides a bit of a buffer to the sponsor to refinance the property. The profit ratio is the difference between the cost of construction and the fair market value after the project is completed and the property is leased. Debt yield ratios are calculated by dividing the property’s NOI by the construction loan amount. Finally, the net-worth-to-loan-size ratio is the property developer’s net worth compared to the requested financing amount. Ideally, the net worth should be as large if not larger than the amount requested to receive approval on a construction loan.

Learn More about Construction Loans

CounselPro Lending offers a wide range of commercial real estate financing from small acquisitions to large ground-up construction loans. Contact our offices today to learn about our construction loans and how we can finance your next project.

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