Construction Financing
What Is Construction Financing?
Construction financing refers to short-term loans provided to fund the ground-up development or major renovation of a property. These loans typically last 12 to 36 months and are interest-only during the construction period.
Unlike conventional loans that are fully funded at closing, construction loans are funded in stages (draws) as construction milestones are met. This reduces lender risk and ensures funds are used as planned.
Key Components of Construction Loans
Loan-to-Cost (LTC)
This ratio compares the loan amount to the total development budget (i.e. the “Cost Basis”). Most construction lenders cap LTC at 65–75%.
Formula:
LTC = Loan Amount / Total Project Costs
Loan-to-Value (LTV)
Once the property is completed, the lender will compare the outstanding loan balance to the appraised “as-complete” value.
Formula:
LTV = Loan Amount / Appraised Value Upon Completion
Interest Reserves
Because construction projects don’t produce income right away, lenders require interest reserves to be funded at closing. This ensures debt service payments can be made during construction.
Draw Schedule
Funds are not disbursed all at once. The lender will fund based on draw requests tied to completion milestones, which are verified via third-party inspections.
Contingency Reserves
Developers must include 5–10% of hard costs as contingency to cover unforeseen overruns. Lenders won’t proceed without one.
Capital Stack in Construction Projects
Construction financing typically comes after equity contributions from managing and limited partners, and before permanent financing:
Managing Partner Equity (risk capital)
Limited Partner Equity (majority equity capital)
Mezzanine Debt or Preferred Equity (optional)
Construction Loan (typically 60–75% of total cost)
This stack must be fully accounted for in the Sources and Uses schedule. Importantly, lenders are always the last to fund—they only disburse after equity is committed and early costs are paid.
What Lenders Require
Before funding, lenders require extensive third-party reports to verify that the deal and development team are solid:
Environmental (Phase I & II)
Property Condition Report (if renovation)
Appraisal ("as complete" value)
Survey (boundary and topography)
Zoning and permits
Construction budget and schedule
General Contractor’s qualifications
Guarantor financials
Lenders will also underwrite the pro forma and stabilization assumptions. That means they’ll model what NOI will be once the property is leased and operating, and whether it will support take-out financing (refinancing into a permanent loan).