A commercial construction loan is a sum of money that is lent to a company that plans to construct a building and a business on a given site. Many companies that build strip malls, residential apartments and condos, and mixed-use buildings need to obtain a commercial construction loan to fund the construction – which can often be a lengthy process.
These loans can often be risky for banks and difficult to obtain. Yet, if you understand the risks involved and the application process, you shouldn’t encounter any major surprises.
- What is a Commercial Construction Loan?
Commercial construction loans are generally loans that are submitted through a local bank, insurance company or finance institution that specializes in such loans. These institutions generally have a solid grasp of the local markets and can analyze a company’s financial situation as well as the value of the land. The land value can be difficult to analyze because there are generally no businesses on the land prior to the loan. Thus, the bank needs to look at other factors to determine if the investment is sound.
The bank might analyze other businesses in the area as well as the profits and losses for those businesses. Usually, the bank will look at other businesses in the loan applicant’s category of work to determine the likelihood of profitability.
- Who needs a Commercial Construction Loan?
Any commercial company that needs to borrow money to build on a site that does not have a current structure will need to seek out a commercial construction loan. This loan may cover costs that include cost of the land, cost of building supplies and cost of construction.
Generally, commercial companies that do not qualify for an investment real estate loan will seek out a commercial construction loan.
The commercial construction loan process can differ significantly from the investment real estate loan process because the bank does not have any previous information to take into account when making the decision. The bank needs to make a decision regarding the loan based on something called the real estate pro forma, which is simply a projection of the expected income of the business. This is similar to a business plan, yet the real estate pro forma estimates how much revenue the property can attract.
A commercial loan has added risks for the bank providing the loan. Many factors can affect the repayment of the loan, such as added construction costs, delays and unforeseen issues in the business. The business may not see a profit in several years because of these factors.
Therefore, the bank must look at all angles of the process. The bank might look into the company’s contractor, building team and business team before making a decision. The past, present and future conditions of the business’s market will definitely be analyzed before a decision can be made.
- How to Obtain a Commercial Construction Loan
The process to obtain a commercial construction loan can be lengthy but efficient. The first step is for the company to fill out and submit a loan through a bank that offers commercial construction loans. Various bank executives will look at the loan and go over the application. The bank will then internally give a yes or no answer. The bank manager may then look over other factors to determine the risks of the loan and the stability of the company’s market. If the loan looks good, the bank manager will approve the initial application.
The bank’s underwriter will then set the terms of the loan in writing. These are simply preliminary terms that the company can look over to ensure the terms meet with the company’s expectations. The company applying for the loan reviews the bank terms. If everything looks good, the company can then sign the terms and approve the loan on its end. This is not a binding contract, yet it sets the stage for the full deal.
The bank underwriter draws up the full and official loan agreement with terms to submit to the company. The company looks over the final agreement and signs it. This contract is the binding contract.
Once both parties have signed the contract, the agreement terms begin. The loan administrator funds the loan to the terms and agreements. Construction can finally begin, and the company can begin making payments as agreed upon in the contract.
- Commercial Construction Loan Terms
Generally, there are two types of commercial construction loan terms: Short-term financing and long-term financing.
Short-term financing is available to a company before a certain point in a project. It can be up until the project is finished or up until the project has reached a certain point. This is generally a point in the project before the construction is complete and before the building is “open for business.” A short-term loan can be available for merely part of the project as well.
Long-term financing is available to companies that want to begin repaying the loan after the project is finished. This can either be once units begin renting within the structure or once the project has reached a maturation date agreed upon by the bank and the company in the original agreement.
A less common type of construction loan is the mini perm loan. This type of loan is a combination of short-term and long-term financing and can assist a company in refinancing and create an operating history.
- Commercial Construction Loan Requirements
Since construction loans can be very risky for banks, the terms may be much stricter than most commercial loans. Some of the requirements needed to secure the loan include asking the company to contribute a minimum percentage of the costs for construction (often 20 to 30 percent of the total cost).
The bank may also need other information, like copies of the company’s tax returns and other financial documents. Companies should also plan to submit lists of current real estate holdings and the financial information for these holdings. The bank may also ask for a copy of the company’s pro forma or business plan for the construction project.
A company is more likely to be approved if a guarantor is included in the project. Like other loans, the company also needs to submit forms that include the projected costs of the project. The bank may ask to see specific plans, including engineering plans. Often, banks will contact the contractor of the project to assess the scope of the project.
What Is Mezzanine Financing?
Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case of default, generally, after venture capital companies and other senior lenders are paid.
Mezzanine debt has embedded equity instruments attached, often known as warrants, which increase the value of the subordinated debt and allow greater flexibility when dealing with bondholders.
Mezzanine financing is frequently associated with acquisitions and buyouts, for which it may be used to prioritize new owners ahead of existing owners in case of bankruptcy.
How Mezzanine Financing Works
Mezzanine financing bridges the gap between debt and equity financing and is one of the highest-risk forms of debt. It is subordinate to pure equity but senior to pure debt. However, this means that it also offers some of the highest returns when compared to other debt types, as it often receives rates between 12% and 20% per year.
Companies commonly seek mezzanine financing to support specific growth projects or acquisitions. The benefits for a company in obtaining mezzanine financing include the fact that the providers of mezzanine capital are often long-term investors in the company.
This makes it easier to obtain other types of financing since traditional creditors generally view a company with long-term investors in a more favorable light and are therefore more likely to extend credit and favorable terms to that company.
A number of characteristics are common in the structuring of mezzanine loans, such as:
- In relation to the priority with which they are paid, these loans are subordinate to senior debt but senior to common equity.
- Differing from standard bank loans, mezzanine loans demand a higher yield than senior debt and are often unsecured.
- No principal amortization exists.
- Part of the return on a mezzanine loan is fixed, which makes this type of security less dilutive than common equity.
- Subordinated debt is made up of a current interest coupon, payment in kind and warrants.
Preferred equity is junior to subordinated debt, causing it to be viewed as equity coming from more senior members in the structure of the capital financing.
Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in the company in case of default, generally, after venture capital companies and other senior lenders are paid It offers some of the highest returns when compared to other debt-linked financing types, as it often receives rates between 12% and 20% per year.
Mezzanine loans are most commonly utilized in the expansion of established companies rather than as start-up or early-phase financing.
The Pros and Cons of Mezzanine Financing
Mezzanine financing may result in lenders gaining equity in a business or warrants for purchasing equity at a later date.
This may significantly increase an investor’s rate of return (ROR). In addition, mezzanine financing providers receive contractually obligated interest payments monthly, quarterly or annually.
Borrowers prefer mezzanine debt because the interest is tax-deductible. Also, mezzanine financing is more manageable than other debt structures because borrowers may figure their interest in the balance of the loan.
If a borrower cannot make a scheduled interest payment, some or all of the interest may be deferred.
This option is typically unavailable for other types of debt. In addition, quickly expanding companies grow in value and restructure mezzanine financing into one senior loan at a lower interest rate, saving on interest costs in the long term.
However, when securing mezzanine financing, owners sacrifice control and upside potential due to the loss of equity. Owners also pay more in interest the longer mezzanine financing is in place.
Suppose you want to buy an apartment building or obtain a commercial loan on a multifamily property. You can quickly compute the value of any multifamily property, if you know that property’s Gross Scheduled Rent and the correct Gross Rent Multiplier for that area. The Gross Rent Multiplier is a number, usually between 3 and 11, by which you multiply the Gross (Annual Scheduled) Rents to obtain a rough estimate of the value of an apartment building. Expressed algebraically:
You’re in a car with your commercial broker, and the two of you are driving around a good rental area in your city, looking for an apartment building to buy. You come to a decent looking building that is for sale. Your commercial broker looks up the Gross (Annual Scheduled) Rents and tells you that they are $263,000 per year. “What’s the going Gross Rent Multiplier for this area?” you ask him. Around seven,” he replies. You multiply $263,000 by 7 to compute a market value of $1,841,000. “What’s the seller asking?” you ask your broker. He replies, “$2,670,000.” “Ha-ha,” you laugh. The seller is on drugs if he thinks that he is going to get that much.” You find another nice building. “What are the Gross Rents of this property?” you ask. “$301,000,” replies your commercial broker. You multiply $301,000 times 7 to arrive at a market value of $2,107,000. ‘What’s the seller asking?” “$1,995,000.” “This looks like a decent value. Let’s get out and walk around,” you reply with interest.
You’re a commercial mortgage broker. A borrower calls you looking for a $3 million multifamily loan. He owes $2,850,000 on the property, and the loan is ballooning. “What’s the building worth?” you ask the borrower. “$4.25 million,” he replies defensively. Instinctually your radar flashes a warning. “He’s lying,” you think to yourself. “What are the gross rents on the building?” you ask the borrower. “$473,000,” he replies guardedly. You’ve lived in Las Vegas your entire life, and there’s a ton of vacant land surrounding the outskirts of the city. The Gross Rent Multiplier in Las Vegas has never exceed 5.5. Five point five times $473,000 equals just $2,600,000. Just $2.6 million? Heck, the borrower owes $2.85 million. This deal is a loser. “Who has turned you down on this deal already?” you ask. “Boston Nation, Pebble Stream Capital, and San Diego Apartment Express.” he replies, naming the three most aggressive multifamily lenders in the market. “Can you bring a load of cash to the closing table?” you ask. “No,” he admits. “Do you own some other property that we can refinance?” “No, just my house, and its has an 80% LTV loan on it.” “I’m sorry, Mr. Borrower, but I can’t help you. You need to do a short sale.” By understanding and knowing the Gross Rent Multiplier, you just saved yourself six weeks of wasted work.
The Debt Ratio is used in commercial mortgage underwriting to make sure the borrower is not overloaded with personal debt.
First Careless Bank makes a $400,000 loan to John Loser to purchase a 6-unit apartment building in the neighborhood. John puts down $100,000 – money that he was given by his aging grandmother to help him get started in the real estate investing business.
The bank doesn’t bother to check out John’s personal financial condition, which is dismal.
John makes just $38,000 a year as a delivery driver for a small chain of flower shops. He has over $32,000 in credit card debt, a $16,000 car loan, and over $175,000 in student loans. John dropped out of college with less than a year left to get his degree in nursing. At first all goes well with the investment. His net income from the property is $4,000 per month, and his new mortgage payment is just $3,100. The extra $900 per month in positive cash flow helps him barely keep up with his bills. Then one of the tenants loses his job and stops paying rent. When John moves to evict him, the tenant gets angry, rips up the apartment, and then disappears in the middle of the night. John has no choice but to take the money he had earmarked for repairs and use it to repair the vandalized apartment unit. Completely out of cash, John can’t afford a painter to cover up some recent graffiti or to repair a huge new crack in the parking lot. With the apartment building showing some wear and tear, he has trouble finding a new tenant. Five weeks go by before a new tenant moves in, and the highest rent that the new tenant is willing to pay is $150 less per month than the prior tenant. Now John is really in trouble because if he doesn’t catch up on this car payments, the bank is going to “pop” the car. Once again he uses the money earmarked for repairs to pay his personal bills. Even more necessary repairs go unmade, and in frustration, two more tenants give notice. The downward spiral continues until the bank forecloses on a run-down, half-empty apartment building with horrible tenants. This all happened because John was up to his eyeballs in personal debt when he applied for the mortgage to buy the six-plex, and he had to use the money budgeted for repairs to cover his personal bills.
The Top Debt Ratio:
The Top Debt Ratio is used to make sure that the borrower is not trying to make payments on a personal residence that is too much house for him. It is defined as follows:
Top Debt Ratio = First and Second Mortgage Payments / Gross Income
Experience has repeatedly shown that whenever a borrower spends more than 25% to 28% of his gross income on his housing expense, he is seriously overextended. This being said, there are, of course, times when an underwriter needs to use some common sense. One is where the borrower has recently graduated with a desirable college degree, and his income in the future is very likely to increase. For example, suppose a young woman graduates from Berkeley with a degree in computer science. She is working at her first programming job, and now she wants to buy herself a starter condo in Silicon Valley. Even though the condo is only 800 square feet, because of the location, its still very expensive – $450,000. If her Top Debt Ratio is 29%, her loan probably should still be approved, especially if she is not burdened with a lot of personal debt.
The Bottom Debt Ratio:
The Top Debt Ratio is used to make sure that the borrower is not trying to make payments on a personal residence that is too much house for him. It is defined as follows:
Bottom Debt Ratio = (Mortgage Payments + Personal Debt Payments) / Gross Income
Experience has repeatedly shown that whenever a borrower spends more than 33% to 36% of his gross income on his housing payments and personal debt payments, he is seriously overextended. Here personal debt payments include credit card payments, personal loan payments, car payments, and student loan payments. It does not include income taxes or utility payments.
In real life, commercial real estate lenders almost never calculate the personal debt ratios of a commercial mortgage borrower. The overwhelming consensus is that if the borrower is wealthy enough to own commercial-investment property and he has good credit, his personal finances are almost certainly in order. While most commercial lenders will gather a financial statement and two years’ tax returns on each borrower, few Loan Committees spend more than 30 to 45 seconds flipping throughout them.
Suppose a wealthy commercial real estate investor owns a commercial building free and clear. A potential buyer makes a good offer on the commercial building, subject to his obtaining a new commercial mortgage loan at 7% from his bank for 75% of the purchase price. The wealthy commercial property owner accepts the offer.
Unfortunately, the commercial lending world is in turmoil right now. Banks are afraid to make new commercial loans for more than around 62% loan-to-value. The bank turns down our borrower’s 75% LTV commercial loan application, and the deal looks like it is going to fall apart.
Then the commercial real estate broker has an idea. He convinces the wealthy owner to carry back a commercial loan for 75% of the purchase price at 7% interest. After all, the wealthy investor owns the commercial building free and clear. The buyer puts down 25% of the purchase price in cash, and the deal closes.
Now let’s scroll forward four years. The stock market has tanked, and the wealthy investor is not so wealthy anymore. He has lost 70% of his stock investments, and now he desperately needs cash to fix up an empty office building that he owns.
He takes his $750,000 first mortgage note that he owns to a number of commercial mortgage companies that specialize in discounting commercial notes. (By the way, if you ever want to sell a commercial note at a discount, please call me,George Blackburne, at 574-360-2486.)
Because his commercial loan has a 27-year remaining term and the note rate is only 7%, he learns that he will have to discount it by close to 28 points in order to sell it. He would have to give up over $200,000 if he tried to sell his note at a discount; and he really only needs the money for about 18 months. He is going to use the money to pay for the tenant improvements on his vacant office building. Once the new tenants move in, he’ll be able to easily refinance the building and pull out lots of dough.
The investor therefore calls his clever commercial real estate broker, and the broker tells him to just hypothecate his first mortgage note. A hypothecation is a loan secured by a mortgage receivable. It’s a loan secured by a loan. In this case, the investor will be pledging his $750,000 first mortgage note as security for a new hypothecation loan of $500,000.
The advantage of hypothecation loan, compared to selling a mortgage receivable at a discount, is that the investor won’t have to discount his perfectly performing first mortgage note by over $200,000. He’ll just pay a modest 3 point loan fee on the new, smaller $500,000 loan. The interest rate on the hypothecation, typically around 12%, is admittedly higher than what a bank would charge for a new commercial loan, but banks are not really lending right now. In addition, our investor really only needs to borrow the money for about 18 months, until his new tenants move into his vacant office building and he refinances the building. It’s far better to pay 12% on $500,000 for 18 months than to suffer a $200,000+ discount if he tries to sell his commercial loan.
Size Standards: : Small businesses must be independently owned and operated, not dominant in its field, and must meet employment and sales standards developed by the SBA. For example, wholesale businesses must not have more than 100 employees. Retail or service businesses must have average three-year annual sales of not more than $5 to $21 million.
Manufacturing businesses should not have more than 500 employees, but in some circumstances, businesses up to 1,500 employees will be considered. Construction companies should have average three-year annual sales of not more than $7 to $17.5 million.
Agricultural businesses must have less that $500,00 in annual sales. These are just some examples of the size limits determined by the SBA. If you are unsure whether or not your business would meet SBA size standards, contact your local agency at www.sba.gov/regions/states.html.
Type of Business: Loan proceeds guaranteed by the SBA cannot be used for the following types of business activities:
- Financing real property to be sold at a later date
- Non-profit work
- Gambling, speculation, lending or investment
- Monopolies and businesses involved in pyramid schemes
- Illegal business activities
Purpose of Loan: Financing may be obtained to establish a new business or to assist in operating, acquiring, or expanding an existing business. Below is a list of accepted uses for SBA loan proceeds:
- To purchase land or buildings
- To cover new construction or the conversion of an existing facility
- For long term working capital such as the payment of accounts payable and/or the purchase of inventory
- To refinance existing business debt that is not already structured with reasonable terms and conditions
- For short-term working capital needs including seasonal financing, contract performance, construction financing, export production, and financing against existing inventory and receivables
Maturity: The rate at which SBA loans mature varies according to the economic life of the financed assets and the applicant’s ability to repay the loan. All loans will be repaid over the shortest possible time period. The following is a list of maximum time periods, varying according to the loans purpose.
- Working capital loans can take up to 7-10 years to mature
- Fixed asset loans can take up to 10-25 years to mature
- Building construction loans can take up to 25 years to mature
Interest Rates: the private lender negotiates Interest rates. They are tied to the prime rate and can be fixed or variable. The SBA has determined that rates on its guaranteed loans shall not exceed 2.25 percent over prime for loans shorter than seven years, and 2.75 percent over prime for loans longer than seven years. Lenders may charge a slightly higher interest rate for loans under $50,000. Most 7(a) loans are amortized using a variable rate.
Guaranty Fee: When the SBA agrees to guaranty a loan, the lender must pay SBA a guaranty fee. Usually, this fee is then passed on to the borrower who can repay the fee from the proceeds of the loan. The fee is based on the loan’s maturity and the portion guaranteed by the SBA.
- For loans with a 12 month or less maturity date, the fee is one-quarter of one percent of the guaranteed portion of the loan.
- For loans with a maturity date greater than 12 months, the fee is three percent on the first $250,000 of the SBA’s share, 3.5 percent on the next $250,000 of the SBA’s share, and 3.875 percent on the final portion of the SBA’s share
Below is a list containing many of the various types of commercial real estate loans. To learn even more about a particular type of commercial loan, simply click on the associated hyperlink.
- Permanent Loans – A permanent loan is a garden variety first mortgage on a commercial property. To qualify as a permanent loan, the loan must have some amortization and a term of at least five years.
- Bridge Loans – A bridge loan is a short-term, first mortgage loan on commercial property. The term could be from 6 months to three years. The interest rate on bridge loans is typically much higher than on permanent loans.
- Commercial Construction Loans – A loan of one to two years used to build a commercial property. The loan proceeds are controlled by the lender in order to make sure they are only used in the construction of the new building.
- Takeout Loans – A takeout loan is a garden variety permanent loan where the proceeds of the loan are used to pay off a construction loan.
- Conduit Loans – A conduit loan is a large permanent loan on a fairly standard type of commercial property, which is written underwritten to secondary market guidelines and which has an enormous prepayment penalty. Such loans enjoy very low interest rates. Conduit loans are later assigned to pools and securitized to become commercial mortgage-backed securities.
- SBA Loans – Loans to users of commercial real estate which are written by private companies, such as banks and specialty finance companies, but which are largely guaranteed by the Small Business Administration. SBA loan guarantees were created by Congress to encourage the formation and growth of small businesses.
- SBA 7(a) Loans – The SBA 7(a) program is a 25-year, fully-amortized, first mortgage loan program with a floating rate, tied to the Prime Rate.
- SBA 504 Loans – The SBA 504 loan program starts with a conventional, fixed-rate, first mortgage and then adds a 20-year fully-amortized, SBA-guaranteed, second mortgage behind it. It is the most common way to get a fixed rate SBA loan.
- SBA Construction Loans – Many SBA lenders will write conventional construction loans that convert automatically to 25-year SBA loans upon completion.
- USDA B&I Loans – The Department of Agriculture’s Business and Industry loan program is very similar to the SBA loan program, where a conventional lender makes the loan but the USDA guarantees most of it. USDA Business and Industry loans were created to help create jobs in rural areas.
- Hypothecations – A hypothecation is actually a personal property loan secured by a note and mortgage owned by the borrower. The borrower’s note and mortgage are often created when the borrower sells a piece of real estate and carries back the financing. Later the borrower might need cash and pledges his mortgage receivable as collateral.
- Fix and Flip Loans – Fix and flip loans are renovation loans that are similar to construction loans. Typically the loan is used to acquire property with enough additional proceeds to renovate the property for a quick sale.