Construction loan repayment - the value of presales and the concept of absorption

Real Estate Developing – The construction loan repayment. Introduction to absorption rates and presales

Chapter – 4 The repayment for the construction loan

If you read chapter 2 of this series, you know that I recommended that you first get a land acquisition loan prior to going for a construction loan. While it is possible to structure both of them together so that a “land acquisition/construction loan” is created, I think it is best to proceed with one first to give you enough time to prepare a strong case for the construction loan portion.

The reason behind this is that while your land acquisition loan will be repaid with the construction loan, the construction loan will be repaid with unit sales or permanent financing.

In the case of units being constructed for sale, the repayment will be from the purchase of the units by the future owners and that is why the concept of a supported absorption rate is useful. Absorption rate is an estimate provided usually by the appraiser in the process of determining a value “as completed” for the project. The way this is determined is through looking at comparables and finding out how quickly similar projects in the area have sold out. It is usually expressed as a { number of units per month ratio }. For example an appraiser might estimate the absorption rate for your twenty unit residential condominium unit to be 5 units a month, which would mean that it will take 4 months to sell the whole building. If the project takes 12 months to complete this means that theoretically you would be done with the sales a full eight months before the end of construction.

In the case of a building being constructed for rental operations, the project would include a “lease-up” period, which would allow for time to reach what is called “stabilization”. The repayment would be the permanent financing in the form of a commercial real estate term-loan.

The value of presales as a source of repayment

This is where the value for splitting the land acquisition from the construction loan shines. Doing it in stages not only allows you the time to get your project budget in place, your permits pulled and your appraisal done, but it allows you to do something, which will strengthen the source of repayment. That something is doing presales.

The fact is most lenders will require enough units to be presold to cover the loan before the loan is closed. This is accomplished by marketing the project to prospective buyers before construction is even commenced. The presales require a deposit. The lender would like to see something in the neighborhood of 10% of purchase price. A presale is not a reservation. Reservation is usually non-binding and has a minimal deposit involved.

For better terms from your lender, your presales must be “quality presales”, which means that no single buyer should be buying more than a single unit, that the ability to run a credit check on the buyers is available, and that a substantial deposit is involved.

The topic of construction lending is vast, in these four articles I covered a small portion of it and only superficially. If you want feedback on a particular project, and I am available feel free to use the forums. Depending on the demand for this topic, I might end up developing more articles and stories around the subject.

Other Articles in the series:
Chapter 1 – Introduction to Construction financing
Chapter 2 – The land acquisition loan
Chapter 3 – Sources and Uses – Loan to Cost and Loan to Value
Chapter 4 – Repayment – Absorption rate – Operating deficit account


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