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Construction and development (C&D) loans are an important financing option for businesses looking to build or renovate commercial real estate projects. As the name suggests, these loans provide funding for the construction or renovation of income-producing and commercial properties. While C&D loans come with greater complexity and risk compared to traditional mortgages, they can also provide significant rewards if done right. This article will break down everything you need to know about construction and development loans, from what they are to how they work.
What Are Construction and Development Loans?
Construction and development loans, also sometimes called construction loans, provide financing to purchase land or property and construct or renovate it into an income-producing or commercial property According to NCUA regulation § 7236, a C&D loan allows a borrower to acquire property or rights to property, including land or structures, with the intent to construct or renovate.
The end goal of a C&D project is to build something new that generates income, whether through rent, sale, or other means. Common examples include:
- Apartment complexes
- Retail spaces
- Hotels
- Office buildings
- Manufacturing facilities
- Warehouses
C&D loans differ from home construction loans or renovation loans in that they fund large-scale, commercial projects rather than residential properties.
How Do Construction and Development Loans Work?
Construction and development loans have a different process and structure compared to a typical mortgage, Here are some key things to know about how C&D loans work
Funding in Phases
Unlike a standard mortgage where you receive the full loan amount upfront, C&D loans provide funding in installments over the course of the project. Disbursements are tied to completion of project phases, allowing the lender to ensure proper use of funds.
Interest-Only Payments
During the construction period, the borrower typically only pays interest on the loan. Principal payments are deferred until construction is complete. This helps improve cash flow during the building process.
Shorter Terms
Construction loans generally have terms of 1-3 years. Once the project is finished, the borrower usually gets permanent “take-out” financing to pay off the construction loan.
Stricter Oversight
Lenders closely monitor C&D projects to ensure adherence to the approved budget and timeline. This includes requiring inspections at funding milestones.
Variable Rates
Construction loans typically have adjustable or variable interest rates since they are considered short-term financing. The rate may fluctuate over the course of the project.
Higher Down Payments
Lenders require a larger down payment for C&D loans compared to conventional mortgages, often 20-30% of total costs. This helps offset the increased risk.
The C&D Loan Process
If you’re considering a construction loan, here is an overview of the typical process:
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Submit a loan application – This includes a project overview, budget, timeline, blueprints, your credentials, etc.
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The lender reviews project feasibility – They analyze the project plan, budget, market, and your ability to repay.
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An appraisal is completed – This estimates costs to complete and projected market value upon completion.
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Loan terms are set – This includes loan amount, interest rate, disbursement schedule, etc.
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Closing and initial disbursement – Initial funds are released to begin construction after closing.
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Ongoing disbursements tied to inspections – The lender releases additional installments upon approving project milestones.
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Construction completion – The project must receive a certificate of occupancy and pass final inspection.
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Final disbursement – Remaining funds are released minus retainage.
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Get take-out financing – You get permanent financing to pay off the construction loan.
Pros and Cons of C&D Loans
Construction financing offers some advantages but also comes with distinct risks and drawbacks.
Pros
- Fund projects that generate income
- Only pay interest during construction period
- Potentially higher leverage than conventional loans
- Ability to customize the property
Cons
- More complex process with stricter oversight
- Higher fees and interest rates
- Time pressures for completion
- Lender able to stop funding if issues arise
- Cost overruns can fall on borrower
- Variable rates can increase payments
As you can see, construction and development loans allow experienced developers and investors to finance large-scale commercial projects. However, they involve much more risk and stringency compared to normal mortgages. Work with a knowledgeable lender and construction team to mitigate the challenges.
Tips for Getting Approved
Because of their inherent risks, C&D loans have stricter approval criteria compared to conventional mortgages. Here are some tips to improve your chances:
- Seek lenders experienced with construction lending
- Have an extensive, detailed project plan and budget
- Get accurate cost estimates from contractors
- Have contingency funds available
- Secure an experienced general contractor
- Provide personal guarantees and larger down payments
- Show you have experience with similar projects
- Demonstrate strong credit history and income
Meeting these guidelines shows lenders you have the knowledge and resources to successfully manage construction risks.
The Bottom Line
Construction and development loans provide an avenue to build commercial real estate projects that generate revenue. However, they involve much more oversight and risk compared to normal mortgages. Working with experienced professionals and following best practices can help you safely navigate the complexities of C&D loans. With proper planning and execution, construction financing can open up opportunities to grow your business investments through custom built assets.
What are construction loans?
Construction loans are loans that fund the building of a residential home (aka a stick-built house), from the land purchase to the finished structure. Common types are a standalone construction loan — a short-term loan (generally with a year-long term) — which only finances the building phase, and a construction-to-permanent loan, which converts into a mortgage once the construction is done. Borrowers who take out a standalone construction loan often get a separate mortgage to pay it off when the principal falls due.
You can use a construction loan to cover such costs as:
- The land
- Contractor labor
- Building materials
- Permits
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Construction Loans: What They Are and How They Work (IN DETAIL)
FAQ
What is the difference between construction loan and development loan?
Why are construction loans hard to get?
What is the minimum FICO score for a construction loan?