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   ARTICLE   |   From Scotsman Guide Residential Edition   |   March 2017

Financing New Construction

Residential homebuilding provides opportunities for borrowers and originators

Custom residential homebuilding has be-come an increasingly popular alternative to the existing, competitive home market. Understanding the process can help originators guide borrowers through the process and close more loans. Direct funding from wholesale lenders is the preferred funding method, but for those times when a borrower’s loan falls outside direct-lending guidelines, it may make sense to partner with a construction specialist.

Construction loans are often one-time close products, which provide funds for construction and then convert to a long-term end loan. Borrowers will need to understand the terms of the final loan. Is it an adjustable rate mortgage (ARM)? If so, what are the ARM terms? Are credit and income underwritten again prior to conversion? Is there a prepayment penalty?

Fees on construction loans can be much higher than for purchase or refinance loans. Title insurance and endorsements are the biggest fees, but third-party fund control also is sizeable. After closing, the construction funds are put into an escrow account. Construction progress is monitored, and funds are disbursed from the account after expenses are justified to reimburse the builder. On some construction loans the client may accept a higher interest rate to reduce closing costs.

Loan options 

Most homes constructed today are stick, or site-built, using lumber-frame construction, as opposed to modular and manufactured housing. In fact, many construction lenders will only lend on stick/site-built projects.

For ground-up new construction, the loan to cost (LTC) ratio is typically used for determining the financing. To determine the cost, processors will need the builder’s estimate for constructing the home, which should include the cost of the land, plus soft costs and hard costs.

Soft costs include permit fees; engineering, surveying and architecture costs; and builder deposits. Hard costs include just about everything else required during construction, including labor and materials. Typical LTC ratios on new construction run between 80 percent and 90 percent.

Rehab-remodel construction loans often use the as-remodeled appraised value to determine a loan-to-value (LTV) ratio — instead of an LTC ratio. This is based on ownership seasoning of 12 months or more. Some lenders only allow an LTV assessment if a certain percentage of the existing structure remains, however. The transaction must be considered an add-on, so a total teardown, where none of the original structure remains, may not qualify. The borrower’s equity requirement is determined by the size and scope of the project. The larger the project, the more of an equity cushion is required.

Construction loans are often one-time close products, which provide funds for construction and then convert to a long-term end loan.

For purchase-remodels, the best approach is a quick, short-term purchase ARM to keep costs down and a construction/remodel loan to pay that off. Although it is possible to do a construction loan as a purchase, the logistics make it unworkable. Sellers want to cash out of their house fast and dislike extended construction escrows. The critical construction-loan documents — design, cost breakdown and contract — usually take 90 days or more to complete.

Some borrowers may want to finance the land needed for a project, but vacant land financing is particularly rare. Although sellers of vacant land often get asked to carry the financing, they would prefer not to do so. Land loans usually take 45 to 60 days to close. Some land lenders require a percolation test or septic approval if the site does not have access to city water and sewers. Either way, the land loan and/or seller financing would be paid off by the construction loan.

Application process

A construction-loan application is similar to a refinance or purchase application. Borrowers must supply in-come, asset and credit documentation. The difference is that construction cost estimates from the builder must be added to the file.

It is not always necessary to have approved building permits or a full set of plans at the time of application, however. A construction loan usually takes 60 to 90 days, and much of that time is spent designing the floor plan and obtaining accurate cost estimates.

Most lenders have a builder-approval process. Owner-builders — where the owner also is the contractor — are rarely allowed. A licensed and bonded general contractor offers professional support and helps the owner through the entire process. A general contractor is the glue that keeps the whole process together by coordinating with all parties involved — originator, Realtor, architect, county-approval departments, and homeowner associations.

A construction contract is usually signed by the builder and borrower prior to work beginning. This can either be a fixed-cost or cost-plus contract. Not all lenders will accept both types of contracts, however. Fixed cost contracts require more precise cost estimates up front and tend to prevent overruns, while cost-plus arrangements are more open-ended.

At the heart of any construction contract is the construction-cost breakdown. This is a list of all the soft and hard costs involved with the home-building project. Soft costs — often called owner items — are paid outside the construction contract, usually prior to closing on the construction loan. These usually are not financed, although they should still be listed in the application for determining the LTC ratio.

Build phase

The size, scope and location of the construction project will determine the amount of time needed for the build phase, which affects the loan duration. Twelve months is standard for most builds, but this timeframe can be extended for larger projects.

Monthly payments during the construction loan can be optional or a requirement, and can be interest-only or principal and interest. These monthly payments will grow as disbursements, or draws, are paid out. The contractor will request draws from the construction-loan funds whenever a phase of the build gets completed. An inspector will visit the site and confirm the work completed before the funds are released.

Once the home is completed, a certificate of occupancy is issued by the local municipality. This is usually the trigger for the construction loan to finish and the long-term end loan to begin. Many borrowers choose to refinance their end loans at this point, especially if the long-term mortgage attached to their one-time-close loan is an ARM. This is a good opportunity for originators to reach out and discuss alternative long-term mortgage options.


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