Why Construction Financing Is Different
Construction loans are fundamentally different from permanent financing in one critical way: the collateral doesn't exist yet. The lender is underwriting a project — a set of plans, a budget, a timeline, and a team — not an existing income-producing asset. This inherent uncertainty is why construction loans carry higher rates, require more equity, and involve more intensive lender oversight than any other commercial real estate financing type.
Understanding how construction lenders think about risk — and how to structure your project to minimize that perceived risk — is the most important skill a developer can develop.
How Construction Loans Are Structured
Ground-up construction loans are short-term, interest-only facilities that are drawn down in stages as construction progresses. Rather than receiving the full loan amount at closing, the borrower draws funds from the loan as construction milestones are completed and verified by the lender's inspector.
Key structural features include:
- Loan-to-cost (LTC): The primary leverage metric for construction loans, typically 65–75% of total project cost. The developer must contribute the remaining 25–35% as equity.
- Loan-to-value (LTV): Lenders also evaluate the completed project value, typically requiring the loan to represent no more than 65–70% of the "as-completed" appraised value.
- Draw schedule: Funds are disbursed in stages tied to construction milestones — foundation, framing, rough-in, drywall, finishes, and certificate of occupancy. Each draw requires an inspection and title update.
- Interest reserve: Many construction loans include an interest reserve — a portion of the loan set aside to make interest payments during construction, reducing the developer's out-of-pocket carrying costs.
- Term: Typically 12–24 months for residential construction; 18–36 months for commercial projects.
What Construction Lenders Underwrite
Construction lenders evaluate five primary risk factors:
Developer experience: This is the most important factor. Lenders want to see a track record of completed projects of similar type and scale. First-time developers face significant challenges accessing institutional construction financing and may need to partner with an experienced developer or accept higher rates and lower leverage from private lenders.
Project feasibility: The completed project must be marketable at a price or rent that supports the loan repayment. Lenders commission independent market studies and appraisals to validate the developer's assumptions about absorption, pricing, and cap rates.
Budget and cost controls: A detailed, line-item construction budget with a qualified general contractor is required. Lenders look for adequate contingency (typically 5–10% of hard costs) and evidence that the budget is based on current market pricing, not optimistic estimates.
Equity contribution and source: Lenders verify that the developer's equity contribution is liquid and available. Equity that is tied up in other projects or contingent on future events is a red flag.
Exit strategy: The lender needs to understand how the construction loan will be repaid — either through a sale or a refinance into permanent financing. A pre-sale or pre-lease commitment significantly strengthens the exit story.
Construction-to-Permanent Loans
Construction-to-permanent (C-to-P) loans combine the construction phase and the permanent financing phase into a single loan with a single closing. During construction, the loan functions as a traditional construction facility. Upon completion and stabilization, it automatically converts to a permanent mortgage without requiring a new appraisal, new underwriting, or a second closing.
C-to-P loans reduce closing costs and eliminate the refinancing risk that comes with a separate construction loan — the risk that permanent financing won't be available at acceptable terms when the project is complete. They are most commonly offered by banks and credit unions for smaller projects and owner-occupied commercial properties.
Maximizing Your Construction Loan
The most effective ways to maximize construction loan proceeds and minimize cost are: building a strong development track record before approaching institutional lenders; presenting a detailed, credible project budget with experienced contractors; securing pre-sales or pre-leases before closing the construction loan; and working with a capital advisor who has established relationships with construction lenders and understands how to present your project compellingly.
At Salt Cove Real Estate Trust, we work with developers at every stage of the capital stack — from initial feasibility through construction financing, mezzanine structuring, and permanent takeout. Contact us to discuss your development project.