Real Estate Developing – Loan to Cost and Loan to Value in a real estate construction loan
Chapter – 3 Construction loan structure – The concept of sources and uses of funds
This is the part of commercial construction lending that is vastly different from the rest of commercial lending. Commercial banks follow a set of underwriting guidelines built into a very thick set of rules called “credit policy”, not only because it is a good idea to have everything in writing, but because as highly regulated institutions banks are required to have a sound “credit policy” to be used as a basis for granting credit accommodations. In the case of construction lending this means that certain things that are specific to construction loans must be included and guidelines must be written down. While you must by now be familiar with the concept of “loan-to-value”, construction financing throws in a slightly different concept called “loan-to-cost”. Let me see if I can summarize both:
Loan-to-value is similar to that of a regular commercial real estate loan. Coming up for a loan-to-value percentage for an apartment building construction, works the same way as if you are buying the same apartment building after it has already been built and occupied with tenants for years. The difference comes when we talk about the way that appraisers arrive to the valuations. It is easy to value an apartment building that is occupied using the income approach all you need is a rent roll, operating expenses and a cap rate. It is a more difficult endeavor to value an apartment building that is yet to be built. The appraiser not only has to come up with a value using a future date, but assumptions on the speed at which the units will be sold or leased, the amount of expenses associated with the process, the interest rates, the level of competition in the area. It can get pretty messy and requires a level of expertise that most appraisers don’t have.
Loan-to-cost on the other hand is a term associated solely with construction loans. It represents the amount of borrowings in respect to the amount of costs associated with the construction of the property until completion. The loan to cost is extracted from the sources and uses of funds schedule, which is prepared from the construction budget for the project.
A simple “sources and uses of funds” will at a minimum breakdown the uses into two categories:
Hard costs: By far the largest portion of the expenses in a construction budget, the hard costs are mostly comprised of the actual construction costs incurred to build the project. In most cases, it will include the land, but that particular cost is usually separated in order to find out the actual construction expenses.
Soft costs: These costs involve all of the other fees involved in the completion of the project. You would include your attorney fees, other professional fees, testing, appraisal, marketing, office, overhead expenses here.
Sources and uses of funds can get lengthy, but it is important for the lender to figure out exactly how much is going to be spent on all of the necessary expenses. It is also important to know where the money is going in order to monitor the progress.
What should you account in your construction budget that you might not normally think of?
Two things come to mind right away: 1) Interest Reserve and 2)Contingency Reserve.
Interest Reserve: This is considered a cost of the project. The construction loan is usually established as an interest only loan for the construction period and only requires amortization once the units are sold. The interest reserve should be accounted for in the budget as part of the total costs. Look at it this way: it might take you 12 months to complete the building and start selling units, but how are you going to pay the monthly interest expense required by the construction loan?
Contingency: The proposed budget should include a certain amount of contingency reserve for cost changes during the construction process.