Construction Loans for
Commercial Real Estate

Ground-Up Construction Financing for Commercial Real Estate

Ground-up construction financing funds the site work and vertical construction of a new commercial project, and it is underwritten against what the project will be worth and earn once it is built rather than against what exists today. INSIGNIA Financial Services arranges construction financing for multifamily, industrial, self-storage, retail, hospitality, healthcare and owner-user projects, and matches each project to the lender and capital stack most likely to fund it through completion and into a takeout.

Construction lending is organized by project stage and by risk more than by product label. A construction lender is underwriting the sponsor, the general contractor, the budget, the lease-up or sales plan and the exit at the same time, and most delays in placing a construction loan trace back to a gap in one of those five areas. The sections below cover the capital sources that lend into ground-up projects, how a construction loan differs from bridge and permanent financing, how construction loans are underwritten and administered, and what lenders expect at takeout.

Capital Sources for Ground-Up Construction

Source descriptions are general. Individual program terms vary by lender and are confirmed for each transaction. Our guide to capital sources and loan types compares these options in more detail.

Construction Loan, Bridge Loan, Construction-to-Permanent and Mini-Perm

Sponsors often use these terms interchangeably, but each is a different structure with a different funding mechanism and a different exit. Choosing the wrong one usually shows up later as a gap in proceeds, a maturity that arrives before the project stabilizes, or a takeout that was never tested.

How Construction Loans Are Underwritten

A construction lender is underwriting completion risk before it is underwriting repayment risk. The areas below determine whether a project is financeable and how the loan is structured.

Sponsor and general contractor

Lenders review the sponsor's completed projects of similar type and size, net worth, post-closing liquidity and ability to fund overruns. The general contractor is reviewed separately for capacity, financial strength, bonding and references. A guaranteed maximum price or fixed-price contract with a qualified contractor is generally expected, and larger contracts often carry a payment and performance bond or an equivalent completion assurance.

Budget and contingency

A lender's cost reviewer tests the budget line by line against plans and specifications and compares hard cost per unit or per square foot with local comparables. Contingency, usually held as a percentage of hard costs, and an interest reserve sized to the construction and lease-up schedule are expected, and soft cost items such as developer fee and financing costs receive close attention. A budget that the reviewer finds light usually resets the loan amount, so the budget should be pressure-tested before submission.

Leverage and equity

Senior loans are sized to the lesser of a loan-to-cost limit, a loan-to-value limit on the as-complete or as-stabilized appraisal, and a debt yield or debt service coverage test on stabilized income. Sponsor equity is generally funded before the first loan advance, and land contributed by the sponsor is generally credited at the lesser of cost and appraised value.

Completion and carry guaranties

Construction loans are commonly supported by guaranties of completion, cost overruns and interest carry from the sponsor or its principals, and the scope and duration of that recourse is a primary negotiating point. Bank loans often carry full or substantial recourse through completion, with release tied to stabilization. Debt fund and HUD structures differ, and non-recourse carve-outs are standard in each.

Pre-leasing, absorption and market support

For multifamily, lenders underwrite rents and absorption against competing supply in the trade area, with attention to concessions and the length of lease-up. For industrial, retail and other income property built on a speculative basis, lenders usually require pre-leasing to a threshold they set, while build-to-suit projects are underwritten on the credit of the tenant and the lease.

Entitlements and third-party reports

Zoning, site plan approval, permits, utility availability and environmental condition must be in place, or have a clear and credible path, before closing. Lenders order an as-complete and as-stabilized appraisal, a Phase I environmental report, a geotechnical report and a plan and cost review. These reports take time and carry cost that should be planned for early in the process.

How Draws and Loan Administration Work

After closing, the loan is administered through a draw process. The process determines how much working capital the sponsor and contractor need and how quickly subcontractors are paid, so it is worth understanding before the loan closes.

• Equity first: sponsor equity and any subordinate capital are generally funded before the first senior advance, although some lenders accept pro rata funding.
• Draw request: the borrower submits an application supported by the contractor's schedule of values, invoices, and lien waivers from the general contractor and major subcontractors.
• Inspection: a construction consultant or lender inspector verifies work in place and percentage complete.
• Title date-down: the title company confirms that no intervening liens have attached before each advance.
• Retainage: a portion of each hard cost draw is held until completion and receipt of final lien waivers.
• Interest reserve: interest on advanced funds is paid from a funded reserve rather than out of pocket, and the reserve is reviewed if the schedule slips.
• Balancing: if the cost to complete exceeds the undisbursed loan and unfunded equity, the borrower must deposit the shortfall before further advances.

Delays at the draw stage most often trace to incomplete lien waivers, change orders that have not been approved, and stored materials that are not properly documented or insured. Agreeing on the process, forms and contacts at closing avoids most of them.

Takeout and Exit Planning

Construction lenders underwrite the exit as carefully as the build, because a loan that cannot be repaid at stabilization becomes a workout regardless of how well the project was constructed. The takeout can be a permanent loan, a sale or condominium sell-out, or conversion under a construction-to-permanent structure.

Permanent proceeds are generally sized to the lesser of three tests: debt service coverage at the permanent loan's rate and amortization, loan-to-value on the stabilized appraised value, and debt yield on stabilized net operating income. We test the takeout when the construction loan is structured, including at higher rates and higher capitalization rates, because a takeout that works only on the sponsor's base case leaves the construction lender exposed to refinance risk and makes approval harder.

Extension options on the construction loan are part of exit planning as well. Most construction loans include one or two extensions, commonly totaling twelve months, conditioned on completion, minimum occupancy, debt service coverage and a paydown if the tests are not met. Borrowers should confirm those tests before closing rather than at maturity.

Typical Program Parameters

The ranges below reflect parameters commonly seen in commercial construction lending. They are indicative, vary by lender, property type, sponsor and market, and do not represent an offer or commitment. Pricing is not shown because construction loans are priced as a spread over an index and depend on leverage, sponsor and structure. Current index levels are shown on our interest rates page.

Our DSCR calculator and other loan calculators can be used to test a project against these coverage levels.

Eligible Project Types

Lender appetite for ground-up construction differs more by property type than for stabilized financing, because the lease-up risk and the exit differ materially from one type to the next.

When Ground-Up Construction Financing Is Not the Best Fit

Construction financing is one tool among several, and some projects are better placed elsewhere. Property that is already built and needs to be repositioned, renovated or stabilized is usually better served by bridge financing. Owner-users with an operating business behind the project can compare SBA 504 and 7(a) and USDA B&I. Projects with substantial energy, water or resiliency scope may reduce senior proceeds with C-PACE, and completed apartment properties may be suited to agency multifamily loans.

Sponsors with no completed projects of comparable scale, a budget that has not been priced by a contractor, or entitlements that are not yet in place should expect lenders to decline, or to require a more experienced co-sponsor, a lower loan amount or a broader guaranty. In those cases the better first step is usually a stronger sponsor team and a priced budget rather than a wider lender search. Builders of one- to four-unit homes, townhomes and small residential communities are covered on our builder finance page, not by the commercial lenders described here.

How INSIGNIA Arranges Construction Financing

INSIGNIA does not lend directly. We arrange financing, which begins with a review of the sponsor, budget, entitlements, schedule and exit, and a decision on the capital stack that fits: the type of senior lender, whether subordinate capital or C-PACE is warranted, and how the permanent takeout will be sized. We then position the request for credit approval, anticipating the questions a credit committee, cost reviewer or investment committee will raise, and coordinate the work that follows: third-party reports, term negotiation, intercreditor and consent issues where the stack has more than one layer, due diligence and closing.

Construction loans carry more documentation, more third parties and more conditions to closing than stabilized loans, so execution certainty often matters more than stated terms. A lender that has reviewed and approved the budget, the contractor and the exit is a better outcome than higher advertised leverage that falls away in due diligence.

Documents Typically Required

• Sponsor and guarantor personal financial statements, schedule of real estate owned, tax returns, and a record of comparable completed projects
• Entity and organizational documents
• Project description, site plan, plans and specifications, and the construction schedule
• Detailed construction budget with sources and uses, and the contractor's schedule of values
• General contractor agreement (guaranteed maximum price or fixed price), contractor financial statements, license, bonding and references
• Zoning and entitlement approvals and building permits, or the status of each
• Land purchase contract or evidence of ownership and basis
• Market study or rent and sale comparables, pro forma, and lease-up or sales assumptions
• Pre-leases, letters of intent or tenant commitments where applicable, and franchise or operator agreements for hospitality and healthcare projects
• Third-party reports, including appraisal, Phase I environmental, geotechnical, survey, and plan and cost review
• Evidence of builder's risk and liability insurance

Ground-Up Construction Loans: FAQs

What is a ground-up construction loan?

It is a loan that funds the construction of a new building on land that has not been developed, typically advanced in draws against a budget while the project is built. The loan is repaid from a permanent loan, a sale or a refinance once the project is complete and, for income property, stabilized.

How much equity is required for ground-up construction?

Sponsor equity commonly runs from 25% to 40% of total project cost, depending on the lender, property type and sponsor. It is generally funded before the first loan advance. Land the sponsor already owns is generally credited at the lesser of cost and appraised value.

How is a construction loan different from a bridge loan?

A construction loan funds the building of a new project in draws against a budget. A bridge loan is short-term financing for an acquisition, pre-development period or transition, with little or no construction funding. A bridge loan is sometimes used to carry land until entitlements are in place and a construction loan can close.

What is the difference between a construction loan and a construction-to-permanent loan?

A construction loan is repaid at completion or stabilization by separate permanent financing. A construction-to-permanent loan closes once and converts to a permanent term loan when the conversion conditions are met, which removes the takeout risk but ties the borrower to the conversion tests and to the lender's permanent terms.

Do construction loans require personal guaranties?

Most do. Banks and credit unions commonly require full or substantial recourse through completion and stabilization. Debt funds typically require completion, cost overrun and carry guaranties with non-recourse carve-outs, and HUD programs are non-recourse subject to standard carve-outs and completion assurances.

What do lenders look for in a general contractor?

Lenders review experience with comparable projects, financial strength, bonding capacity, licensing, insurance, references and current backlog. A guaranteed maximum price or fixed-price contract, and in many cases a payment and performance bond, is expected.

How do construction loan draws work?

The borrower submits a draw request with invoices and lien waivers. An inspector verifies the work in place, the title company confirms no new liens have attached, and the lender funds net of retainage. If the cost to complete exceeds the remaining loan and equity, the borrower must fund the shortfall before further advances.

What is an interest reserve?

An interest reserve is a portion of the loan budgeted to pay interest on advanced funds during construction and, in many structures, lease-up. It lets the project carry its own financing cost before it produces income, and lenders size it to the schedule and review it if the schedule slips.

Can C-PACE or preferred equity reduce the equity I need to contribute?

They can, where the senior lender consents and the project supports the additional carry. C-PACE is limited to eligible improvements in an authorized jurisdiction, and preferred equity and mezzanine debt add cost and intercreditor complexity. We test the combined stack against the takeout before recommending it.

Can construction financing include the land purchase?

Many construction loans fund part of the land cost, and land the sponsor owns is credited toward equity. Where land is acquired ahead of entitlements, a bridge or land loan often carries the property until a construction loan can close.

How long does it take to close a construction loan?

Timing varies by lender and program and depends on how complete the budget, plans, contractor agreement, entitlements and third-party reports are at submission. Construction loans take longer than stabilized loans because of the cost review, appraisal, environmental and permit steps, and HUD structures take longer still. We confirm timing with the lender before a client commits.

Why use an advisor for construction financing?

Lender appetite for construction varies by property type, market and sponsor, and capacity changes with each institution's concentration limits. An advisor with relationships across banks, credit unions, debt funds and government programs can identify which lenders are active for a given project, structure the request and the takeout together, and manage the process through closing.

This page provides general information for business users and does not constitute an offer of financing or a statement of current pricing. Terms vary by lender, property type, sponsor credit and program requirements, and all loans are subject to credit approval. Summaries of government and regulatory programs are general and are not legal or regulatory advice.