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Commercial construction loans

September 13, 2022

In this podcast, Mike Luster, Executive VP and Commercial Loan Officer at Cape Ann Savings Bank, talks with John Maher about commercial construction loans. Mike explains how businesses use these loans and what to expect when they apply.

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Podcast transcription

Transcription Disclosure: Below is a transcript of the conversation between John Maher and Mike Luster. Please note, this is an unedited "word for word" rendition of the actual conversation and is not intended to be grammatically correct.

John Maher: Hi, I'm John Maher. I'm here today with Mike Luster, Executive VP and Commercial Loan Officer at Cape Ann Savings Bank. Today, we're talking about commercial construction loans. Welcome, Mike.

Mike Luster: Thanks, John. Thanks for having me, and looking forward to the discussion.

Uses for Commercial Construction Loans

John: Great. So, Mike, what is a commercial construction loan, and what can they be used for?

Mike: Yep. Good place to start. Commercial construction loans, the main reason, the one that comes to mind first, John, is... Let's call it a business owner that wants to expand their current space. They may have owned their property for years. They're starting to outgrow it. They might need to go back to the bank and say, "Listen, I want to put a 40x40 edition on my building. I have it permitted. I'd like to expand. And what do I need to do?" We would provide a construction loan for them to do that.

Speculative Commercial Construction Loans

A construction loan is also used for two different purposes that the layman may not know. They don't hear these terms every day, it is a speculative construction loan and a construction-to-permanent loan. A speculative construction loan would be a property developer or property investor who owns a piece of land and wants to construct homes on it to sell. Or this person might buy a four-family, and they want to turn that into four condos that they want to sell off. That's a typical speculative construction loan. The reason it's speculative is because we don't really know the repayment at this time. The repayment is going to come from the sale of the units or sale of the homes when the construction is completed.

Construction-to-Permanent Loans

The other type I talked about is construction to permanent, where that property investor or property developer might want to build... They have a permit to build a six-family home, or they have a permit to build a mixed-use property. They build this six-unit home, but they don't want to sell off the units. They want to rent them. That's more of a construction-to-permanent loan, where the payback is going to come from the rental income that they receive from their tenants.

Those are the three different types, business expansion, or that business person that wants to build a factory or a restaurant, speculative construction, or construction to permanent.

Who Provides Construction Loans?

John: Okay. And who provides construction loans?

Mike: Mostly banks do. Small banks, large banks. Both community banks and the larger banks will provide construction loans.

Requirements for Construction Loans

John: Okay. And what are the requirements in general for getting a construction loan?

Mike: The requirements are very similar to a normal business mortgage or commercial real estate loan. You always need to have accurate, up-to-date financials, because we always look to the borrower or the developer as the main person involved in that loan, so we want to make sure that they've maintained their financials. We want a personal financial statement to see what that borrower's net worth is. But most of all, it's important to come to the table with plans and an accurate breakdown of construction costs. I can't tell you how important that is.

And it's for two reasons. Because when we distribute the proceeds after the loan closes, we're going to distribute the proceeds of this construction loan based on that predetermined construction cost breakdown that the borrower provided. But even more importantly is that when we appraise that property or when we have someone appraise that property, right now, they're looking at a piece of land. How are they going to give you a value a year from now? Well, they're going to use the construction cost breakdown that you provided and the set of plans you provided, and they're going to do what's called an as-complete appraisal.

That gives the bank comfort, knowing that a qualified, licensed appraiser looked at the costs, looked at the plans, came up with an as-complete idea in their mind, and then they compared it to similar properties that have been completed, and then they give you a value of that as-complete project.

When we do a construction loan, we typically get an as-is value based on the land or the property as it currently stands, and then we provide the appraiser with the construction costs and the plans that they're going to follow to give us an as-complete value of that property. It's the only way we would be able to do it. And then when we advance the funds, we know that the property is being built in the correct specifications in accordance with that appraisal. So it's important to have accurate, up-to-date financials. We need to get a personal financial state. But most important, we need plan specs and construction costs. One thing that's important, too, is that we want to know that the person has experience in developing the properties as well. So we might want to see a short bio or some references as well.

How As-Complete Value Affects Construction Loans

John: Are you looking for that as-complete value to be a certain percentage higher than the construction costs or anything like that? Or is that on a case-by-case basis?

Mike: Excellent question. And you're talking like a bank examiner, John. We want the as-complete value. We always have to maintain that certain level of loan-to-value in accordance with our bank policy, so we want to make sure that the as-complete value is always going to have enough collateral coverage. Meaning if the construction loan is a million dollars, we want to make sure that that is no greater than 80% of the as-complete value as the project goes on. So yeah, that's very important, that we maintain the proper loan-to-value all the way through the construction process up until it's completed.

John: Typically with a home construction or something, everybody always talks about how the construction costs get inflated, and it always ends up costing more than you expected it to initially. Do you take that into account as you're looking at that initially when giving the loan?

Mike: Yes. We encourage our applicants to provide us with a number in the construction cost breakdown for a miscellaneous number or a contingency number. We also ask them to double-check with their subcontractors to make sure. Because we typically don't like to have them come back for additional funds.

We want to know that they did their homework up front. But also, we know… look what's happened over the last 18 months or two years with construction materials. Anybody that started a construction job in early 2020 that was going to finish in early 2021 were paying 30 or 40, maybe even 50% more on their materials. That one would've been hard to predict. But we typically try to work with our applicants to provide us with that contingency or cushion in the numbers, and if they don't need it, they don't need it. But that does happen quite often, and we do try to work with the developer or the homeowner to plan ahead.

Process of Obtaining a Construction Loan

John: Can you walk me through, Mike, the process of getting a construction loan? What's the first step?

Mike: The first step in applying or getting a construction loan, we like to sit down with the borrower, ascertain what their background is in construction. Or if it's a homeowner on the residential side, we want to make sure that they're using a licensed general contractor to do the work. But on the commercial side, we want to make sure that that borrower has the experience to pull this off. We want to make sure that they have their construction costs and their plans. And we want to go over the plan and the timeline.

We also want to sit down with the borrower up front and let them know, "Listen, when you go to request an advance, we're going to want to see invoices, and we're going to want to see bills. We need the backup for the funds that you are requesting. We don't want to see advances from our loan go into other projects or to help fund other things. We want to match the advanced request with the invoices." And so we try to be as forthcoming as possible up front with that at the beginning, just so they know what they're getting into, that not only do you have to be a good builder or a good project manager, you also have to be a good business person that maintains accurate files of invoices, because we're going to want to see the backup. So it's important to communicate with the borrower up front to know going in that, look, we're not looking for you just to pound nails here. You really need to have your files straight, and you really have to be organized, because we have to document everything in the construction loan process. So it's important to communicate with them up front to let them know what the bank's requirements are as well. The other requirement would be, like I said, accurate financials.

Then we get all that to an appraiser to make sure everything jives. We want to make sure that the number that they tell me they're going to sell the properties for or what they think the property's going to be valued at, we want to make sure that that's accurate in the form of the appraisal. So those are the basic requirements: accurate construction costs, plans, and then we want to communicate to them exactly what our process is, because there is some documentation that goes on.

What Does a Construction Loan Cover?

John: And does a construction loan cover equipment or machines that I might need for my business, or is it just for the construction or expanding on the building itself?

Mike: No, that goes back to a previous podcast, John. Any type of vehicle or equipment loan should be based on that piece of equipment and that vehicle. That's a separate business term loan. Construction loans are based on the construction of that particular project. And it goes back to what I talked about with the appraisal. When we provide the plan, specs, and a construction cost breakdown to the appraiser, it has to be built in accordance with that.

If a borrower says, "Oh, I need $40,000 from this construction loan to buy this mini excavator," we can't have that, because that $40,000 was supposed to be used for windows. So that's a totally separate credit facility that that developer or contractor would need to do. He'd have to use a shorter-term business loan to buy a piece of equipment or a vehicle. Where the construction loan, that has already a predetermined outcome, $40,000 for windows, $20,000 for electrical. That's already been determined. So good question. And that's something we definitely want to communicate to the developer or the homeowner, is that these funds need to be used for the specified purpose.

Contact Us to Talk About Construction Loans

John: All right, well, that's really great information, Mike. Thanks again for speaking with me today.

Mike: Thank you, John. John: And for more information on commercial lending or business loans, visit the website at Cape Ann Savings Bank, Member FDIC, Member DIF, Equal Housing Lender.

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