Here is how commercial construction loans are underwritten. The first test is the profit test. Will your finished project be worth more than it will cost to construct? Most lenders will require at least a 20% profit margin.
A related test is the loan-to-value ratio. After the project is completed and, say, your strip center is occupied, will the construction loan be less than, say, 75% - 80% loan-to-value.
Commercial construction lenders often will not trust the appraisal. Instead, they will look to the loan-to-cost ratio. What percentage of the total cost is the construction lender being asked to cover?
Developers are usually asked to cover at least 20% of the total cost of the project, usually in the form of free and clear land or cash (possibly you and an equity partner). After all, the construction lender wants the developer to have some skin in the game.
However, commercial construction loans up to 90% of cost, or more, are possible. And if the developer needs even more leverage, a mezzanine loan is sometimes possible if the primary lender allows additional leverage behind its position. It is hard to find mezzanine loans for less than $2 million, although it is sometimes possible to find one as small as $1 million. Mezzanine lenders will usually only fund projects that are worth at least $10 million. Another alternative is to find an equity partner through a JV structure or Preferred Equity structure.
The commercial construction lender will want a viable takeout strategy. If you build your strip center, will the center make enough money to qualify for a takeout loan large enough to pay off the construction loan? A takeout loan is just a long-term first mortgage on the property.
To determine if the takeout loan is large enough to pay off the commercial construction loan, the construction lender will compute the Debt Service Coverage Ratio. It is calculated by taking the annual net operating income divided by the annual debt service. The ratio must usually be larger than 1.25. In other words, the net income from the project must be 25% larger than the proposed payments.
Finally the commercial construction lender will look to the developer's “net worth-to-loan size” ratio. Generally the developer's net worth should be at least as large the loan amount. Not meeting this requirement may not disqualify you for financing based on other factors.
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Vice President, Cressida Capital
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