Commercial Magazine

Navigate the Paper Shuffle of Financing

Managing the construction-loan approval process requires staying on top of the details

By Garry Barnes

The United States is considered one of the largest construction markets in the world, with the construction industry serving as a major contributor to the nation’s economy. It is estimated there are more than 650,000 construction companies and more than 6 million employees building approximately $1 trillion worth of facilities annually.

Given this volume of new construction, it seems obvious to have a strong demand for construction financing. This creates great opportunity for the commercial mortgage broker who has experience with and knowledge of the construction-lending process.

Of course, the financial objective of developing a property is to produce enhanced value beyond the cost of development. Put differently, the full value of the project is dependent on what the predictable value of the project will be once complete.

It should be remembered that construction projects are high-stakes propositions. Regardless of project size, investors assume a lot of risk, which includes time, money and human capital.

Mitigating risk

Construction lending requires a comprehensive understanding of the fundamental processes associated with this type of credit transaction. A construction lender will experience higher risks not generally found in long-term financing of an existing property. There are many ways, however, to mitigate these risks.

Commercial mortgage brokers normally will not be involved in all of the collection and analysis of the various documentation involved in the construction- financing process. Still, it is imperative for the broker to understand the importance and rationale of each document in order to explain the relevance of each step in the process and advise the borrower correctly.

The full value of the construction project is not realized until the facility is complete and ready for occupancy. During the construction period, which may last a year or two — or perhaps longer on larger projects — many changes can occur that may negatively impact the as-completed appraised value.

Such disruptive events could include new competition, a decrease in rents, waning market appeal for the project, overspending or the wrong location. These are just a few value disruptors that can have long-lasting effects on a project.

Mortgage underwriting is a systematic process used by the lender to determine if the challenges associated with the loan request are generally acceptable and fall within the lender’s defined risk parameters. Most of the risks, terms and conditions considered fall under the five C’s — credit, character, capacity, collateral and conditions.

Once the loan request is underwritten and approved, it then becomes the responsibility of the loan administrator (or closing department) to document the loan consistent with the lender’s approval standards, which is a paper-intensive process and involves documents required by state and federal laws, as well as contractual bank documents that require the participation of many outside sources.

Standard documentation

The following information is an abridged version of the documents and steps required to close a typical construction loan. It may not be a complete list because of different lender policies and procedures, as well as variations in state real estate and banking laws. The information, however, can serve as a good initial template for the construction-financing process for those interested in exploring the niche.

Loan commitment. Once approved, transactions of a certain size and complexity will be communicated to the borrower, in writing, in the form of a detailed commitment letter. This communication is a formal document stating the loan has been approved, subject to various preconditions and/or contingencies that must be met prior to closing and funding the loan.

The format will vary from lender to lender, but tends to be lengthy and very detailed. Generally, the commitment letter is required to be signed by the borrower within a relatively short time period, maybe 10 to 15 days, and is frequently accompanied by the payment of a commitment fee.

Loan agreement. A construction-loan agreement is a contract between a lender and a borrower, which recites the crucial terms under which the loan is granted — including the many promises the borrower makes to the lender. This is generally a detailed document and sets forth the many representations and warranties that are required before the loan can be funded.

Primarily, the lender will want the borrower to promise to complete the work in a timely manner, get necessary permits, and comply with all laws and building codes. The many funding requirements will, of course, vary from lender to lender and project to project.

There are several fundamental elements, however, that are included in most construction-loan agreements, such as the loan amount, the appraised value and a take-out (or permanent) financing arrangement. Other contractual elements include:

A commitment of borrower equity.

A description of the collateral.

Personal guarantees.

Draw procedures for loan-fund disbursements.

A deposit-account requirement.

Covenants (affirmative and negative).

Lender approval of all changes to plans.

Insurance requirements.

Other documentation

Draw procedures. A draw, or partial release of the loan proceeds, normally occurs as a certain amount of work on the project is completed. Upon completion of a designated amount of work, the contractor will submit a draw request to the lender for review and approval.

The construction-loan agreement usually establishes the frequency and written procedures to be followed, including the necessary documentation needed to approve the draw request. Also, in some cases, the lender will combine the loan agreement and draw procedures into one document.

Construction contract. The construction contract has many different format options, but should incorporate complete details of the entire project, including any off-site improvements. The contract is originally negotiated between the investor/borrower and the general contractor.

Because the contract is normally assigned to the lender, it should be methodically reviewed by a senior credit officer and, in many cases, the lender’s legal counsel. If, in the future, the lender finds it necessary to exercise its rights under the assignment, there should be no surprises.

The contract will include various conditions and contingencies that must be met in order to close and subsequently fund the project. A few of the basic requirements include pricing, with either a fixed rate or variable rate (cost plus). The latter option is less desirable for borrowers but may be appropriate under certain conditions. A specific completion date should be clearly defined as well as how change orders will be handled. Modifications that change the scope of work and/or the amount of the contract require lender involvement.

Advance holdbacks, also known as retainage, must be clearly defined. Retainage is a certain dollar amount of the total contract that is withheld from the contractor, pending verification that the work has been completed according to owner specifications and local building codes, and that all material invoices and subcontractors have been paid. The retainage allows the borrower and lender a degree of financial leverage over the contractor and final completion of the project.

Building plans. Building plans are an architectural representation of what a building will look like after construction. They are used by builders and contractors to construct buildings of all kinds. Building plans also are useful when it comes to estimating project costs and preparing budgets.

The lender should always obtain a full set of plans to be held in their files until the project is complete. If a contractor problem develops during the construction process and the lender is forced to replace the builder, the new contractor will need a complete set of building plans to move forward with the project.

Construction budget. The construction budget is an estimate of the total money needed for a specific building project. A budget is a comprehensive review of the individual expense items and is normally tracked using a detailed spreadsheet. A clear and concise budget format will divide the data into easy-to-read divisions or categories — such as separating soft costs (architect, engineering, appraisal and developer fees) from hard costs (land, materials and labor).

It’s also important to delineate the interest reserve, which is the line item that pays interest expenses during construction. Another category that deserves separation is contingencies, which will cover unanticipated costs and overruns. The precise budget format will depend on the individual preferences of the lender, but it should ensure a precise understanding of the project’s progress in relation to its associated expenses.

Skin in the game

Equity contribution. Construction lenders normally require the borrower to make a downpayment — often 20 percent to 30 percent of the loan amount. The exact amount will vary depending on the borrower/lender relationship, loan amount or duration, project type or other terms.

In addition, if the borrower owns the land free and clear, it may be used as the equity contribution for the project. The amount of equity contributed to the project will have an influence on fees, the interest rate and other terms and conditions of the loan.

The greater the contributed equity, the stronger the negotiating position of the borrower. Maybe the most important aspect about borrower equity is that it must be put into the mix in advance of any loan disbursements.

Prepaid expenses. Periodically, a contractor will get a head start on the project and may pay for certain expense items in advance. In some cases, the contractor will request credit toward their equity contribution. This process is normally acceptable, but the lender will require a detailed listing of all expenses supported by paid invoices, or receipts for specific items and their related costs.


  • Garry Barnes

    Garry Barnes is managing director of PW Partners Consultancy, headquartered in Salt Lake City, and is a freelance writer. He is a former president and CEO of banks in Arizona, California and Utah. He has taught at the university level, and is a frequent writer and lecturer on banking, finance and real estate matters. Barnes has served on the U.S. Small Business Administration’s National Advisory Council and received the SBA Arizona Financial Services Advocate of the Year award.

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