What Is A Commercial Construction Loan?
A commercial construction loan is a type of loan that is used to finance the costs associated with the construction or renovation of a commercial building. The funds from a construction loan can be used to pay for labor and materials for the construction of a new property, the purchase and development of land for a new commercial property, or the renovations of existing properties.
Why Take Out A Commercial Construction Loan?
Business owners who plan to purchase existing commercial properties can get a loan known as a commercial mortgage. However, if you plan to renovate your existing space or construct a new building from the ground up, you’ll need to apply for a commercial construction loan.
New construction and renovations can be expensive — think hundreds of thousands or even millions of dollars. Most growing businesses don’t have this type of cash on hand, so instead, they turn to a commercial construction loan. With commercial construction loans, lenders provide funds throughout the construction process to pay for labor, materials, and land development so you don’t have to cover the costs yourself.
How Commercial Construction Loans Work
Commercial construction loans are different from other loans. Most loans are structured so that the borrower receives the full amount of the loan as one lump sum. Once the loan is received, the borrower begins to pay back the loan through scheduled payments over a set period of time. Commercial mortgages, for example, often have a monthly repayment schedule over 10 years or longer.
With commercial construction loans, the full amount of the loan is not received up front. Instead, the borrower will work with the lender to create a draw schedule. This means that partial amounts of the loan will be released as the project hits new milestones. For example, the first draw will be for the clearing and development of land. The next draw may then occur when the foundation is poured. Another draw will be released when the building has been framed, and so on.
As each milestone is completed, a lender will typically require an inspector to confirm that the work is completed before releasing the next draw. This will continue until all milestones have been completed and the full amount of the loan has been distributed.
With a commercial construction loan, you will only pay interest on the portion of the loan proceeds that have been received. If the total cost of your new construction is $500,000 but the lender has released just $100,000, you will pay interest on $100,000.
Typically, a commercial construction loan is structured so that the borrower pays only the interest until the loan has been fully disbursed. Borrowers can then pay off the principle in one lump sum at the end of the construction project.
But once the project is done and the full amount of the loan is due, what does a borrower do next? Instead of having to make one large payment, the borrower now can receive a commercial mortgage. The property will serve as collateral, and the borrower will use the funds from the commercial mortgage to pay back the commercial construction loan. With the new mortgage, the lender will now be locked into more affordable monthly payments over a longer period of time.
Other commercial construction loans like the Small Business Administration CDC/504 loan provides more long-term options so an additional loan following the completion of the project will not be needed.
For commercial construction loans, borrowers should expect to pay interest rates between 4% and 12%. Borrowers with the best credit scores will receive the lowest interest rates. The type of lender you work with is also a factor. A commercial construction loan from a bank will typically have the lowest interest rate, while hard money lenders charge more interest for their loans.
There are several fees that may be associated with taking out a commercial construction loan. The fee types and amounts vary by lender. Some fees you may have to pay for this type of loan include:
Project review Fees
Fund control Fees
Because a commercial construction loan is a high-risk loan, a down payment is required. By paying a down payment, the borrower takes some of the risk off of the lender. Typically, down payment requirements are 10% to 30% of the total project cost. Rarely will a lender fund 100% of the costs of a commercial construction project.
Conventional lenders use a calculation known as loan-to-cost for commercial construction loans. The loan-to-cost ratio is calculated by dividing the total amount of the loan requested by the total project cost. Let’s say, for example, a business is requesting a loan of $190,000 for a project with a total cost of $200,000. The loan-to-cost in this example would be 95%.
Though requirements vary by lender, most require a loan-to-cost of 80% to 85%. For the example above, the lender would loan $160,000 at 80% and $170,000 at 85%.
If this occurs, what does the borrower do? While they may be forced to come up with the remaining costs out-of-pocket, there is another option — mezzanine loans — which we’ll discuss a little later.
Borrower Requirements: How Commercial Lenders Evaluate Eligibility
Not all construction projects are eligible for a commercial construction loan. There are several factors that a lender will consider in order to determine eligibility.
One of the first things that a lender will look at is your credit score. Because these are high-risk loans, lenders want to work with low-risk borrowers with high credit scores. Though credit requirements vary by lender, you should have a credit score at least in the high 600sbefore applying to qualify for loans such as the SBA CDC/504 loan. Other lenders may require a minimum score in the 700s. Business credit scores will also be evaluated.
The lender will also consider your debt-to-income ratio, also known as DTI. This ratio shows the relationship between the income and the debt of your business on a monthly basis. Typically, lenders look for a debt to income ratio of 43% or less, although some lenders may have stricter requirements. The lower your DTI, the higher your chances for approval. To calculate your DTI, use the following formula:
Total Monthly Debt Payments / Gross Monthly Income = DTI
Lenders will also consider your debt service coverage ratio, or DSCR. This shows the relationship between the income and debt of your business on an annual basis. To calculate for yourself, use the following formula:
Net Operating Income / Current Annual Debt Obligations = DSCR
The DSCR is a bit different from DTI because you want this number to be higher. This shows that your business is bringing in enough income to cover new debts. Most lenders look for a DSCR of 1.25 or higher, but again, requirements vary by lender. Learn more about calculating your DSCR.
The lender will also look at your industry experience and your current business financials to determine if you qualify for a loan. You’ll need to submit detailed construction plans for approval before a loan can be issued. In some cases, the plans may need to be altered based on any risks spotted by the lender, so your ability to be flexible in your plans is key.
Types Of Commercial Construction Loans
Now that you know more about the commercial construction loan process, it’s time to explore the different types of loans available.
SBA CDC/504 Loan Program
The Small Business Administration (SBA) CDC/504 loan is one of the most popular commercial construction loans. This is because these loans come with low down payments, competitive interest rates, and credit score requirements in the high 600s.
No maximum, but the SBA will only fund up to $5 million
10 or 20 years
Fixed rate based on US Treasury rates
CDC servicing fee, CSA fee, guarantee fee, third party fees (however, most of these fees are rolled into the interest rate or cost of the loan)
Possible prepayment penalty
Guarantee required from anybody who owns at least 20% of the business
Collateral required; usually the real estate/equipment financed
10% - 30%
With this loan, an SBA-approved Certified Development Company will fund 40% of the costs to renovate existing facilities, build new facilities, or purchase/improve land. Up to $5 million is available for borrowers.
Another lender will need to provide 50% of the project costs, while the borrower will be responsible for the remaining 10%. In some cases, borrowers may be required to pay 20%. Repayment terms are available up to 20 years, and interest rates are based on the market rates of U.S. Treasury issues.
SBA 7(a) Loan Program
The SBA also has the 7(a) program, which can be used for the purchase or construction of commercial real estate.
Through this program, borrowers can receive up to $5 million with repayment terms up to 25 years. Interest rates are based on the prime rate plus a maximum of 2.75%. To qualify, borrowers should have a credit score in the high 600s and a down payment of 10% to 20%.
Here are the base rates and markups for a 7(a) loan from the SBA:
Loan AmountLess Than Seven YearsMore Than 7 Years
Up to $25,000
Base rate + 4.25%
Base rate + 4.75%
$25,000 – $50,000
Base rate + 3.25%
Base rate + 3.75%
$50,000 or More
Base rate + 2.25%
Base rate + 2.75%
A traditional commercial construction loan from a bank is another option for business owners. Rates, repayment terms, and down payment requirements vary. Generally, a minimum down payment of 10% is required, maximum repayment terms of 25 years are standard, and fixed and variable rates are available. You can start your lender search by talking to your current financial institution about your financing needs. See our post on the best bank loans for small business if you’re interested in specific recommendations.
Earlier in this post, we discussed loan-to-cost ratios. When a loan-to-cost ratio is lower and the borrower needs to come up with additional money, a mezzanine loan may be an option. This type of loan is secured with stock. If the borrower defaults, the lender can convert to an equity stake. With a mezzanine loan, the borrower has more leverage and can achieve a loan-to-cost ratio of up to 95%.