Construction Loan

What Is a Construction Loan?

A construction loan is a short-term commercial real estate loan that funds the ground-up development or major renovation of a property. Unlike permanent loans that provide a lump sum at closing, construction loans release funds in stages (called draws) as work progresses and milestones are verified by independent inspectors. Terms typically run 12 to 36 months, with the expectation that the borrower will refinance into permanent financing or sell the property once construction wraps up.

How Construction Loans Work

The mechanics of a construction loan differ significantly from a standard commercial mortgage. The lender commits a total loan amount based on the project budget, but doesn't fund it all at once. Instead, the borrower submits draw requests as construction reaches predetermined stages, and the lender sends an inspector to verify the work before releasing funds.

This draw process protects the lender from funding a project that stalls or goes sideways. It also means the borrower only pays interest on funds that have actually been disbursed, not the full committed amount. Most construction loans are interest-only during the construction period, with no principal amortization until the loan converts or refinances.

Construction Loan Terms

Types of Construction Loans

Ground-up construction: Funds the complete build of a new structure from an empty lot. This is the highest-risk construction loan category because there's no existing asset generating income. Lenders scrutinize the development budget, construction timeline, general contractor qualifications, and market demand for the finished product.

Substantial rehabilitation: Funds a major renovation that effectively transforms the property. Think gut renovations, adaptive reuse projects (converting an office building to apartments), or adding significant square footage. Lenders underwrite these similarly to ground-up deals because the scope of work is extensive enough that the existing structure provides limited collateral value.

Construction-to-permanent (C2P): A single loan that starts as a construction loan and automatically converts to permanent financing once the project is complete and stabilized. C2P loans eliminate refinance risk and save on closing costs but typically come with less favorable permanent terms than shopping the market after completion. Some HUD 221(d)(4) loans function this way for multifamily new construction.

Who Makes Construction Loans?

Commercial banks and credit unions: The largest source of commercial construction financing. Banks typically offer the lowest rates (7-9%) but require full recourse, completion guarantees, and often want pre-leasing or pre-sales before committing. Banks tend to work with developers they already have relationships with.

Debt funds and private lenders: More flexible on sponsorship requirements, property types, and leverage. Rates run higher (9-12%) but these lenders can move faster and take on projects that banks won't touch, like speculative developments without pre-leasing. Many debt funds have dedicated construction lending platforms.

Government-backed programs: HUD's 221(d)(4) program provides non-recourse construction-to-permanent financing for multifamily projects with terms up to 40 years. The SBA 504 program can fund new construction for owner-occupied commercial properties. Both offer favorable terms but involve lengthy approval processes.

Construction Loan Sizing

Construction lenders size loans primarily on loan-to-cost (LTC) rather than loan-to-value (LTV). The total project cost includes land acquisition, hard construction costs, soft costs (architecture, engineering, permits, legal), interest reserves, and contingency reserves (typically 5-10% of hard costs).

A lender offering 70% LTC on a $15 million total project cost would commit a $10.5 million construction loan. The developer brings $4.5 million in equity. Lenders also check the loan against the projected stabilized value (as-completed LTV) to make sure the finished property supports the debt at a reasonable DSCR.

The Draw Process

After closing, the borrower doesn't receive the full loan amount. Funds are held in reserve and released through a draw schedule tied to construction milestones. A typical process looks like this:

• Borrower completes a phase of work (foundation, framing, mechanical systems, etc.)
• Borrower submits a draw request with contractor invoices and documentation
• Lender sends a third-party inspector to verify the work is complete and matches the approved budget
• Lender releases funds, minus any retainage (typically 5-10% held until project completion)

Draw processing usually takes 5 to 15 business days. Developers need to plan for this lag when managing cash flow and paying contractors.

Key Risks in Construction Lending

Cost overruns: Construction projects regularly exceed initial budgets. Lenders require contingency reserves (5-10%) to absorb overruns, but if costs spiral beyond the contingency, the developer must inject additional equity. This is the most common point of stress in construction deals.

Timeline delays: Weather, permitting holdups, labor shortages, and supply chain issues can push completion past the original loan maturity. Most construction loans include extension options, but extensions cost money and may require performance milestones.

Lease-up risk: Even after the building is done, it needs tenants. If lease-up takes longer than projected, the borrower may struggle to refinance into permanent financing before the construction loan matures. This is why many lenders want to see pre-leasing before they commit.

Completion risk: The lender's worst scenario is a half-built property. That's why nearly all construction lenders require completion guarantees from the sponsor, personal guarantees ensuring the project will be finished regardless of cost overruns or other issues.

Construction Loan vs. Bridge Loan

What Brokers Should Know

Construction deals are more complex to broker than stabilized acquisitions or refinances. The underwriting involves project budgets, construction timelines, general contractor qualifications, and market feasibility studies on top of the usual sponsor financial review. Brokers who can package a clean construction deal with a detailed budget, realistic timeline, and strong contractor resume will stand out to lenders.

The construction loan deals guide covers the full process for getting these deals across the finish line, including how to structure the deal package and navigate common lender objections.

Frequently Asked Questions