Lenders view construction loans as short-term, high-risk, high-yielding investments. They must follow strict procedures to mitigate risk and ensure a good relationship between the outstanding loan balance and the collateral value.
One of the keys to successful construction lending on the financial institution side is never to advance money to a project until after progress has been validated—and never fully fund a project ahead of its completion.
Construction lenders will typically advance funds for these purposes:
- Land acquisition costs
- Engineer and architect fees
- Survey costs
- Title insurance costs
- Legal fees
Contractors submit monthly progress payment requests as materials are purchased and construction proceeds. These requests outline the work completed to date, the construction funds previously received, and the new amount being requested. One of the best ways for banks to keep track of draw requests is to invest in construction loan management software, which is proven to help mitigate risk associated with inefficient loan monitoring and decrease the probability of default.
Another critical component for a successful construction loan is an organized budget, which should be broken down into hard and soft costs.
Hard costs include the physical elements of the project, such as:
Soft costs include the pre-construction costs, such as:
- Plans
- Permits
- Engineering tests
- Bank or legal fees
Budgets also should include a contingency that will act as a reserve to cover unexpected costs, such as rising prices or weather delays. A 10% budget contingency is the rule of thumb to cover unpredictable factors, but one size does not fit all. The contingency should be adjusted for the current environment, so consider poor weather, supply chain issues, and other market factors that may make a 15-20% contingency more prudent.
The loan-to-value (LTV) ratio, or the relative difference between the loan amount and the project’s market value, will determine what borrowers need to provide in equity. The lower the LTV, the less risky the project is for your financial institution. If your bank policy allows an LTV of up to 80%, then borrowers’ equity will be 20%.
This doesn’t mean that borrowers need to provide equity in cash. Unencumbered land counts as equity, as do valid project costs already paid before the loan is made. But whatever remaining balance there is after accounting for those costs must be paid by the borrower at the closing table.
