Construction Financing Loans: How to Secure Funding for Your Next Commercial Project

What Are Commercial Construction Financing Loans?

Commercial construction financing loans are a funding option available to help build or renovate a commercial property.

These loan products are unique as funds are released in specific phases, referred to as “draws.” So instead of a lump sum, funds are available after certain milestones are met.

While in the construction phase, borrowers may only make interest-only payments on the actual amount drawn at that time, instead of the whole amount.

Types of Construction Financing Loans

Commercial construction loans can come in different forms. Here we cover some common types of financing.

1. Construction-Only Loans

Construction-only loans provide funds to build or renovate a property and may have a short repayment term, often one to three years. Sometimes they’re also called stand-alone construction loans.

You have a specific draw schedule based on milestones and pay interest only on the amount drawn. At the end of the term, borrowers must pay the remaining balance with a balloon payment or take out another loan and refinance to pay off the loan. As a result, this generally has two different closings and additional fees.

2. Construction-to-Permanent Loans

If you want to avoid two closings, you can look into construction-to-permanent (CP) loans. These combine construction loans and permanent mortgage loans.

So, while the building is under construction, you’ll typically pay interest-only on the drawn amount. When the project is complete, the loan transitions to a more traditional commercial mortgage with a longer repayment term. Because It's a single product with two options, borrowers pay closing costs once.

3. SBA Loans

The U.S. Small Business Administration (SBA) also has loan options that businesses can use toward construction.

Qualified businesses may be able to secure construction financing loans through the SBA 7(a) loan program or with an SBA 504 loan.

The 7(a) loan funds are eligible for acquiring and improving real estate, with a maximum loan amount of $5 million.

The 504 loan funds can go toward land or new facilities, with a maximum loan amount of $5.5 million.

Key Features of Commercial Construction Financing Loans

Here we cover key features of commercial construction loans.

1. Loan Amounts

Minimum and maximum loan amounts on construction loans can vary by lender. While they may be higher than traditional mortgage loans, borrowers’ credit history, experience, project costs, and viability all impact what you can qualify for.

Some metrics that lenders may use are loan-to-cost (LTC) or loan-to-value (LTV). Loan-to-cost ratio evaluates the loan amount against total costs, while loan-to-value considers the loan amount relative to the estimated value of the property once it’s completed.

2. Repayment Terms

Construction financing loans are significantly different from traditional mortgages when it comes to repayment terms. Instead of a 15-year or 30-year repayment term, construction loans are generally much shorter. In fact, repayment terms may be from one to three years, for construction-only loans.

3. Interest Rates

New construction loan rates may depend on your project, credit profile, loan size, repayment terms, market conditions, and lender. Typically, commercial construction financing loans have variable interest rates.

Eligibility Requirements for Commercial Construction Loan Funding

Businesses looking to secure commercial construction financing loans must meet the eligibility requirements set by the lender. Generally, these are more stringent and difficult to obtain than traditional mortgages.

1. Down Payment

Construction financing loans don’t have the built-in collateral like a traditional mortgage, with the property not being built yet. There’s no existing property for a lender to seize if the loan isn’t repaid.

As a result, these loans are considered higher risk and generally have higher down payment requirements. For example, down payments may range from 10% to 30%, depending on the lender.

2. Credit Score

Lenders review your credit history to evaluate risk and your payment history as a borrower. Your credit score provides a financial snapshot to lenders, providing insights on the likelihood that you can manage and repay the loan.

Minimum credit score requirements may range from lender to lender but generally start at 680 or higher.

3. Debt-to-Income Ratio (DTI)

Though construction loan lenders review your business finances, they may review your personal credit score and debt-to-income (DTI) ratio as well.

Your DTI is the percentage of your income required to manage all of your obligations. According to the Consumer Financial Protection Bureau (CFPB), to calculate your DTI take your monthly debt payments and divide it by your gross monthly income. To get the specific percentage, multiply the number by 100.

Lenders may have DTI benchmarks and prefer borrowers with a DTI of 43% or less. Having a lower DTI shows lenders that you can manage the debt you have and aren’t overextended.

4. Debt Service Coverage Ratio (DSCR)

While debt-to-income typically refers to an individual borrower’s finances, debt service coverage ratio (DSCR) is a common metric for commercial construction and real estate loans. It’s a metric that highlights financial strength, showing how a property’s net income can cover its debt obligations.

The debt service coverage ratio formula takes he net operating income (NOI) and divides it by the total debt service. Though benchmarks can vary, Avana Capital notes that construction lenders generally want a DSCR of 1.25 or higher, though requirements vary.

5. Construction Plans

To assess the viability of the project, lenders may also review your construction plans. When you’re applying for construction financing loans, it’s key for lenders to understand the vision and potential costs for the entire project.

These may include:

• Architectural blueprints
• Estimated budget
• Construction timeline
• Permits
• General contractor agreements

The more details you provide, the better, so the lender can understand the scope and scale of what you plan to do.

Documents Needed to Apply for Construction Loans

Some documents you may need when applying for commercial construction financing loans include:

1. Business plan
2. Blueprints
3. General contractor agreement
4. Project overview
5. Estimated budget
6. Personal tax returns
7. Business tax returns
8. Financial statements
9. Bank statements
10. Permits
11. Project timeline

Common Challenges When Securing Construction Financing Loans

As a higher-risk product, it can already be challenging to qualify for construction financing loans. But even if you meet the eligibility requirements and get the loan, there are some common challenges that can arise. These can include:

• Rising costs: With inflation, labor and building materials may increase in cost.

• Project delays: There are many moving parts in a construction project, and timing isn’t totally in your control. You might face permit delays, supply chain issues, or the contractor is taking more time to complete the project than you thought.

• Eligibility or application challenges: Some things that can stop an application from moving forward are insufficient down payment, missing or incomplete documentation, unrealistic budgets, poor credit, and lack of supporting documentation.

How to Prepare Your Application

If you’re considering construction financing loans, here are some ways you can prepare your application to limit delays and improve eligibility.

1. Keep Your Credit in Good Shape

Keep both your personal and business credit in good shape. Always make your payments on time and only borrow what you need.

2. Create Accurate Budgets

It’s essential to create accurate budgets when you’re applying for construction financing loans. These include hard and soft costs, such as land, building materials, labor, fees, permits, contingencies, and more.

3. Work with Vetted Professionals

When you’re constructing a commercial building, you’ll need to work with a general contractor or a team to perform the work.

These professionals can significantly impact the process and timeline. Working with vetted professionals can ensure you get the results you want and can stick to the timeline. Check credentials and licenses and contact references.

4. Prepare Financial Documentation

Your financial documents, like tax returns and profit and loss statements, should be recent. Gather both personal and business tax returns for the last several years. Review your documents for potential inaccuracies or discrepancies that could delay your application. Include detailed budgets and project details.

5. Compare Lenders

When researching options for commercial construction financing loans, it’s important to compare several lenders. You want not only competitive rates and a clear repayment structure and term, but a lender that has expertise in your industry.

Final Thoughts

Paying out-of-pocket for construction or renovation is out of reach for many business owners. Commercial construction financing loans can provide the funds required to get started, while helping you manage costs and cash flow.

Understanding how these loans are structured and working with a reputable, experienced lender can reduce potential delays and keep the project on schedule.