Demystifying Construction Loan Underwriting Criteria
Construction loans are story loans. That means the lender has to know the story behind the planned construction before theyre willing to lend money. To adequately tell the story, the borrower needs to provide the lender with the following critical documents.
Construction Cost Breakdown: When underwriting a commercial construction loan, four major categories of costs are involved:
1. Land Costs are the total costs associated with acquisition of the land.
2. Hard Costs are direct contractor costs for labor, material, equipment, and services; contractors overhead and profit; and other direct construction costs.
3. Soft Costs are cost items other than hard costs. Soft costs generally include architectural and engineering, legal, permits and fees, financing fees, construction interest and operating expenses, leasing and real estate commissions, advertising and promotion, and supervision.
4. Contingency Reserves are always built into the budget to ensure the project will be completed if there are cost overruns. This contingency is normally calculated at 5% of the total cost of construction.
Draw Schedule: Commercial construction lenders generally provide a schedule of draws (a periodic advance of funds), either at regular intervals during construction or upon completion of specific segments of construction. The borrower should be prepared to provide the lender with a draw schedule based on timing and costs of the project.
Feasibility/Marketing Study: Developers conduct market studies to determine the best location within a jurisdiction and to test alternative uses for a given parcel of land. Jurisdictions often require developers to complete feasibility studies before approving a permit application for retail, commercial, industrial, manufacturing, housing, office or mixed-use projects.
Architectural Drawings: Lenders require a complete set of drawings for the proposed project, including, among other documents, a site plan, floor plan, side and front elevations, as well as mechanical and electrical plans.
5-Year Financial Projections: The experienced developer will prepare a comprehensive financial model for the project, including five years of projected data required to prepare standard financial statements (income statement, balance sheet and statement of cash flow). In addition, the lender will require a five-year summary of these financial statements.
Company and Personal Financial Statements: Every commercial construction lender will require current and historical (usually three years) financial statements from both the company requesting the loan and the companys principals.
Following are the bases under which a commercial construction loan is underwritten.
Profit Test: Prudent commercial construction lenders will require an internal rate of return (IRR) to the sponsor of at least 20% over 5 years following completion of the project. Lenders also will require a feasibility/marketing study to support the projections used in the IRR calculations.
Loan-to-Cost (LTC) Ratio: Commercial construction lenders often will not trust the appraisal of a proposed property. Instead, they will look to the LTC ratio (percentage of total cost the construction lender is being asked to cover). Traditionally, commercial construction lenders will only lend up to 80% of total cost. If a property type is out of favor with investors, however, some commercial construction lenders might consider no more than a 70% loan-to-cost ratio.
Debt Service Coverage (DSC) Ratio: To determine if the takeout loan will be large enough to payoff the construction loan, the construction lender will compute the DSC ratio. This ratio is computed by dividing the projected annual net operating income by the annual debt service (principal and interest payments). The net operating income of the property is the income left over after operating expenses such as taxes, insurance, repairs, and management costs, plus estimated vacancy losses, collection losses, and replacement expenses, such as a new roof or heater. In general, the DSC ratio must be larger than 1.25. In other words, net income from the project must be at least 25% larger than the projected annual debt service.
Net-Worth-to Loan Size Ratio: Finally, the lender will look to the developers net-worth-to-loan-size ratio. Generally, the developers net worth should be at least as large as the loan amount. The ratio is calculated by dividing the developers net worth by loan size. This should be greater than 1.0. During recessions, banks often require this ratio to be as high as 1.5.
Questions and Answers
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