Construction loans are typically a second mortgage registered against the property where the construction is taking place. If there isn’t sufficient value in the underlying property to secure construction financing, then other security would also have to be provided to the lender.
The basic premise of a construction loan is that money will be advanced to complete a predefined stage of work. Once the stage is completed and inspected, the property will have increased in value, providing additional security value for draws or advances for future stages of building.
Construction loan amounts as a percentage of the overall project cost can vary considerably depending on the lender and the specific project. For instance, some construction financing programs are capable of funding 100% of the building costs, where others require the borrower to provide an equity investment at the beginning or end of the project.
The equity portion can also vary considerably among lenders. For lower risk, lower cost construction financing, the equity portion required by the borrower will be higher and range from 50% of the total project costs up to 75%. In many cases, the key risk element that can separate lower cost lenders from higher costs lenders is the amount of equity the borrower has available to invest in the project.
Keep in mind also that the borrower will also need to cover off inspection, appraisal, legal, and administrative costs as well as any taxes associated with the construction project, which are all costs above and beyond the actual project costs considered for financing.
Construction capital products can also be quite specialized among residential home and commercial building applications. Larger, more complex commercial projects tend to have a smaller lender population that can be more international in nature as the related funding sources primarily focus on the same types of large projects over and over again.
Construction related capital may also be connected or disconnected from the longer term mortgage instrument. A connected construction financing facility will provide advances for construction and once the project is completed, the total advances will be immediately rolled into a long term mortgage.
A disconnected construction loan would be totally independent from the longer term mortgage and would likely involve two separate lenders, one for the construction portion, and one for the long term mortgage.
Because of the risks associated with any construction project, there is much greater lender interest in financing a completed building than one under construction, so its not uncommon for the construction financing piece to be stand alone capital that needs to be paid out by a separate lender.
Regardless of the size of construction loans, accurate estimates and solid project management are the keys to getting the projects completed within in the funding approved. Cost overruns and delays can result in capital shortfalls that may not be easily covered off.