In commercial real estate, new construction projects typically entail far more risk than other investing strategies (e.g. value-add, buy-and-hold, etc.). But, a new development also has the potential for far higher return on investment. As such, people often ask us about how commercial construction financing works. In the rest of this article, we’ll explain how to receive commercial construction loan approval. 


Specifically, we’ll cover the following topics: 


  • An Overview of Commercial Construction Loans
  • The Steps to Commercial Construction Loan Approval
  • Final Thoughts


An Overview of Commercial Construction Loans 


Prior to discussing the approval process, we need to explain commercial construction loans, in general. With the caveat that every lender will have slightly different requirements and procedures, here are three defining characteristics of this type of financing: 


Short-Term, Interest-Only Financing


Construction loans are a source of short-term financing – typically anywhere from six months to three years, depending on the project. And, due to the higher risk on a construction loan (as the underlying collateral isn’t completed), construction loans tend to have slightly higher interest rates than permanent mortgages. These rates also tend to be variable, pegged to some index (e.g. LIBOR, COFI, etc.). 


But, commercial construction loans are also normally interest-only – not amortizing like a permanent mortgage. This allows developers to finance new projects while limiting their cash requirements during construction, when the property isn’t generating income. Most deals include an interest-reserve period, also, during which the developer pays the interest on the outstanding loan with draws on that loan, itself. Then, at the conclusion of the construction period, the developer will refinance the construction loan into a permanent mortgage.  


No “Pre-Approval” – Depends on the Deal


With residential mortgages, smart buyers apply for loan pre-approval before looking for homes. Unfortunately, no equivalent process exists with commercial construction loans. Each commercial deal is unique, meaning that a lender cannot generically pre-approve a borrower for financing. Rather, potential borrowers must submit a detailed application package specific to a particular deal. The lender will then review this submission to approve or deny financing.  


Draw-Style Disbursement – No Lump Sums


Similar to residential construction loans, commercial ones do not issue lump-sum disbursements. To mitigate risk, lenders issue funds with a series of draws. As the general contractor finishes certain milestones on the project, the developer will submit draw requests to pay for the work that has been completed. That way, the lender has only risked the construction costs to date – not the entire loan amount – in case the deal falls apart. In theory, the lender will then be able to recoup the outstanding loan balance during the foreclosure process, regardless of a project’s level of completion. 


The Steps to Commercial Construction Loan Approval


Step 1: Confirm a Commercial Lender’s General Financing Requirements


As stated, each lender will have slightly different loan approval requirements and procedures. While you won’t receive construction loan pre-approval, it’s wise to establish a relationship with a commercial lender before making an offer. That way, you’ll know exactly what supporting information to gather when you formally apply for construction loan financing. 


Additionally, most commercial lenders will require verification of a borrower’s personal finances, despite the fact that you’ll be applying for commercial financing (often in the name of an LLC). During this initial step, you can gather and provide this information to the lender. 


Step 2: Make an Offer on a Parcel of Land  


With a new construction project, you need land. If you already have a parcel in a development land bank, this step doesn’t matter. If not, you’ll need to make an offer. Ideally, the land will be zoned for the commercial use desired (e.g. light industrial, commercial, mixed-use, etc.). If not, part of the purchase offer will include a re-zoning contingency, stating that you will apply for a change in zoning, and closing will be contingent upon approval. 


The purchase offer will also include a feasibility period clause. This allows developers to, after making an offer, confirm that construction and financing for that particular project makes sense. 


Step 3: Confirm the Design and Contractor Bids


In particular, this feasibility period gives would-be buyers the opportunity to commission architectural plans. The architect will then bid these plans out to general contractors in a formal bidding process. After helping vet potential bids, you and the architect will then A) select a general contractor for the project, and B) receive the detailed construction costs for the project. 


Step 4: Underwrite the Deal


Armed with architectural plans, acquisition and construction hard costs, and associated soft costs, the developer can then underwrite the deal. In simple terms, underwriting means running the numbers on a deal. That is, will the projected rental income generated by the stabilized property cover its operating costs and debt service? And, will these stabilized operations justify a valuation that will allow permanent financing to pay off the construction loan balance? 


Step 5: Submit the Financing Package to the Commercial Lender


Assuming your deal passes underwriting muster, you will submit the final construction financing package to the lender. This will include the personal financial information discussed above plus all of the deal-specific requirements. While ever deal differs, here are some of the lender requirements you can expect to submit: 

  • Project team (architect, GC, property manager, etc.)
  • Site information (survey, zoning information, environmental work if required, etc.) 
  • Construction cost breakdown and construction schedule
  • Financials for the GC
  • The stabilized pro forma for the property


Step 6: Close on the Deal


After you submit the above financing package, the lender will review it. In all likelihood, the lender will come back with questions and additional requirements as they conduct their own due diligence. 


Eventually, you will receive approval to close. During the closing process, you’ll sign the associated loan documents, submit the deal-specific down payment, and pay closing costs. Once closed, the lender will issue the first draw, which will typically cover land acquisition and the initial phase of construction. 


Final Thoughts


New real estate investors may not want to individually dive directly into a commercial construction project. But, that doesn’t mean that opportunities don’t exist to invest in these sorts of deals. If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities.