| It would seem that construction activity is still fairly high | | | | Q: What’s a contingency reserve? |
| based upon the number of calls that I get from people | | | | A: This is another chunk of money set aside in the loan |
| about construction loans. There are a lot of calls from | | | | to protect you against cost overruns. Since it can take |
| people just getting started, as well as from a number | | | | a year or more to complete a project, the prices used |
| of seasoned “construction veterans.” In a large | | | | to estimate the construction budget become less |
| number of those calls, I hear some common questions. | | | | accurate as time marches on. The contingency |
| So I thought that I’d answer a few of them here. | | | | reserve is released a little bit at a time during the |
| Q: How do construction loans work? | | | | construction process to cover inevitable price |
| A: In general, just like every other loan. You sign loan | | | | increases. |
| documents and money is funded into escrow. In the | | | | Q: How do you calculate the maximum construction |
| case of a construction loan, only a portion of the total | | | | loan? |
| loan is released. The balance is released either in | | | | A: The maximum construction loan is based upon |
| preset “stages” or as workers complete | | | | many factors: Property type, stabilized value at |
| portions of the project according to a budget. The | | | | completion, total costs, and equity invested to name a |
| former is called a “draw” system and the latter | | | | few of the key concerns. For any given property type, |
| is called a “voucher” system. | | | | there is usually a maximum “loan to costs” and |
| Q: How are the payments calculated and who makes | | | | a maximum “loan to value.” The key is this: The |
| them?” | | | | largest permanent loan for which the property can |
| A: Commercial loans have the added security of an | | | | qualify, assuming it is built and fully occupied or valued, |
| income producing property providing the funds to pay | | | | will limit the construction loan. This is because the |
| the loan payments. For residential loans, it’s the | | | | construction lender wants to be paid off at the end of |
| borrower’s income. When a property is being built, | | | | construction and the way to do that is with a |
| there is no secondary source of repayment so the | | | | permanent loan. This does not mean that if the |
| burden of payment would normally fall to the borrower. | | | | permanent loan exceeds the total costs of the project |
| But lenders didn’t want borrowers to use up all of | | | | that you can get 100% construction financing. Just |
| their funds in case something went wrong with the | | | | about every lender is going to look for 10% to 20% of |
| project, so they created “interest reserves.” This | | | | the total costs to be funded by equity or cash from |
| is a chunk of money set aside in the loan to do nothing | | | | the borrower. |
| but make the loan payments during the construction | | | | I hope that these few examples clarify some of the |
| process. The payment is based upon how much | | | | questions that you might have concerning construction |
| money has actually been used or “drawn” at | | | | lending. I’ll cover more here in the future. If you |
| the time the payment is due. This is not the case for | | | | should have a question that wasn’t covered, email |
| private money lenders. They calculate interest on the | | | | me at your convenience and I’ll do my best to give |
| entire amount of the loan from the initial funding date. | | | | you a complete answer. |