Contractor Funding: How to Finance Your Large Construction Project
Photo by Daniel McCullough
Originally Posted On: https://newslo.com/contractor-funding-how-to-finance/
So you’ve got a large construction project on your mind. Alright, what next?
You need contractor funding! But you have no idea as to how to finance your expensive project.
One would think that acquiring funding is as easy as going to the bank.
But… That’s where most are wrong – keep reading to find out all about large construction funding: the basics of construction finance, requirements from both parties (fund and contractor) and the various different types of sources for finance.
Construction Finance Basics
Before we even begin to talk about the different types of funding – we need to cover the method in which the construction loan works, what are the costs involved and metrics that a lender will evaluate to make their decision.
The most basic principle of contractor funding is double-fund. Meaning that instead of acquiring all of your funding at once, you will actually need to finance two separate periods of loan usage – each being weighed and calculated at a different risk level.
The first period covers any activities during construction, this period is funded through a construction loan.
The second period, as you would think, funds the after-construction time frame with a permanent loan.
In most cases, an owner develops the financing flow by contacting a real estate holding company, which would be responsible for the construction property and any of the loans, as to prevent any unnecessary risk for personal parties involved.
What Is a Construction Loan?
A construction loan, as mentioned earlier – covers any necessary costs required up-front and during construction. With this type of funding, you will be responsible for making interest-only contributions during the construction period.
This means that after construction is complete, you will be left to pay the entire principal value of the loan + any leftover interest. The quicker you are able to complete construction, the less surcharge through the interest you will have to pay.
After the completion of initial construction, your property is bound to reach a state of stabilization, which is evaluated when your property is worth more in raw value than the principal loan amount.
At this phase, a lending institution will account for your facility as collateral, in order to mediate its own risk involvement. However, not all properties are subject to stabilization, unless the facility is residential and has the expectancy of rental occupancy.
What Is a Permanent Loan?
When your property has stabilized, you will be proposed a permanent loan, which often has a much lower interest rate than that of the construction loan. A permanent loan is usually enabled, in order for you to pay off the entirety of the construction loan and spread out the payments with a lower interest.
After receiving a permanent loan, you are responsible for following the chosen repayment schedule in full.
A permanent loan can be replaced with a combination loan, which would place external requirements, such as:
– stabilization conditions are determined before construction begins
– interest rate is negotiated in advance with payment plan enabled during stabilization
To fund a large construction project, your best bet is to make use of a balloon permanent loan, in which you are responsible for making low monthly contributions (usually interest-only) for a determined period of time, and then pay off the rest with a settlement payment.
The problem with such a loan is that they are difficult to acquire without managed relationships and impeccable loan history.
What Is the Profit Test?
When a lender evaluates your construction potential, they employ the use of a standard profit test, which determines stabilization. To begin, a lender will research your ownership group and their experience from any prior construction projects, also they will take a look at the contractors executing the plan.
After this is done, they will use two separate measures for determining how invested you are in this construction.
A loan-to-value ratio (LTV) = loan sum / estimated value of property
A loan-to-cost ratio (LTC) = loan sum / cost of project
The lower the outcome of the LTV and LTC is – the less risky the project will be for the lender, making it easier for you to acquire a loan without collateral or personal guarantee.
However, most lenders will not contribute to the entire sum, but only loan out 3/4 of the project value.
Guarantee and Collateral
In most contractor funding scenarios, the lender will use the property itself as collateral. If you default the loan, the lending institution takes ownership of the facility.
Depending on the project, the lender might choose to take land collateral over the property. As some properties are harder to re-sell or repurpose than others. For example, a parking lot has limited use, while an office complex can be rented out to many different people.
Considering the financial constraints of the current credit environment – a lender will ask you to provide a personal guarantee, where any of your investors will sign a contract that they will be responsible for paying the loan if the project fails or defaults.
Personal guarantees can be several or joint, capped or unlimited in their value. Before you borrow a loan, you will be asked to present all of your personal liabilities and assets, with the promise of updating this information on a pre-selected time period.
What Are the Main Project Costs?
Before you even set out to look for loans, you should already have a project plan developed. In this plan, you are responsible for outlining the four cost categories associated with your project.
Hard Cost – the cost of construction labor and any materials required.
Soft Cost – permit costs, architectural planning costs, engineering contractors cost, tax costs, Insurance costs (title, contingency, builder risk, liability), developer fee, legal costs, appraisal costs, construction interest, inspection, etc.
Land Cost – land and property acquisition cost.
Contingency Reserve Cost – reserve fund established for interest payments, pre-determined reserve level (5+ % of soft cost)
If you do not provide this information to a lender, it will be very difficult for you to secure contractor funding and complete the project.
Sources of Contractor Funding
The availability of contractor funding sources for your project is determined, by the type of project involved. However, for the sake of portraying the options, here they are:
- Private Financing
- Public Financing
- Government Programs
- State-Specific Funding Options
- Increment Financing
- Industrial Revenue Bonds
- Historic Tax Credit
These are just some of the options, which we will delve into deeper.
Sources of Private Financing
For most people, a private contractor funding source will be the easiest to acquire. For example, a bank loan is the most common of construction funding sources in the construction industry.
They are valuable to a contractor, as a local bank is aware of the local environment and can appraise a project, based on its region placement. A bank loan is usually insignificant and covers projects under $5 million.
Another source is a construction lending bank – these banks specialize in construction projects. These institutions possess relevant construction experience and can on-board the project, as trusted advisors.
A construction lending bank usually provides a loan under a high-interest rate and compensation fees.
A lending exchange is another form of private financing. For example, a C-Loan acts as a visual representation for your project, in order to gather funding from many lenders. You provide the exchange with pertinent information and construction plans – the exchange considers the project, and sends it out to those lenders who they think will be most interested.
The best way to secure private construction funding is to either know people who are able to provide such financing or directly contact your local bank and lending authority to set up an appointment for discussion.
If neither option works out for you, CIG Capital is a great place to start. The founder, Charles D. Carey, would be more than happy to help you out, in finding the best solution for your project.
Sources of Local Government Financing
Depending on where you are, your local government head should have developed affordable financing programs for all sorts of construction projects.
For example, the SBA offers the 504 loan program, which is provided for commercial construction projects. It is provided to a mid-to-small sized business, up to a summation of $20 million.
An SBA loan helps you save capital and reduce/eliminate unnecessary tax rates – by letting you secure the loan with only a 10% down payment but using your land as equity.
This type of government funding provisions lengthy amortization, usually ranging 25 years for a construction loan, and 20 years for a permanent loan. However, you are limited with property execution, as you are only allowed to lease up to 40% of a constructed property to any other business, and up to 45% of an existing property that you decide to upgrade in any shape or form.
In order to find the right government financing for you, you should visit your local government websites and look in the financing/funding section.
TIF – Tax Increment Financing
Within the United States of America, any region that has many old or vacant buildings reduces the overall property value of the area. The aim of a TIF is to improve the base property value and generate revenue from sales tax, by the method of involving foreign investments in their region.
A tax increment = the property tax evaluation after construction – the property tax evaluation before construction.
Through a TIF program, you are able to pay the interstitial costs for construction, but as the value of the project and the TIF region increases, these changes in value will pay you a dividend tax increment.
In order to secure a TIF, you have to show that your property is increasing in value, but also helping other properties in the TIF area increase their value. This sounds dandy, but what are the cons of a TIF?
Acquiring a TIF is not simple, it requires lengthened review from the public upon the value of your property. Your property also has to reside within a TIF area, and sometimes these districts are severely limiting in scope. Another problem of a TIF is based on the spending limitations.
A TIF can only be spent on things like infrastructure development or other similar ventures.
Securing a TIF will reduce overall costs, but often must be matched with a primary funding source, in order to properly build the project – making the total cost, higher than it could be.
Industrial Revenue Bond
An IRB is a type of loan, provided by your local government authority to help fund the construction or purchasing of property equipment. Any interest on this loan is exempt from tax for the lender, which helps reduce your interest contributions.
Another benefit of an IRB is the length of a payment schedule being set for periods of 20 to 30 years, unlike a private bank which would often shorten the period.
A single IRB cannot exceed the cap of $10 million, and an IRB cannot be used in the construction of a project that is evaluated at more than $20 million. With the current credit environment, securing an IRB can be difficult. Nevermind, the limitations.
Federal Funding Programs
Federal funding is vast, and it would take a while to discuss all of the loan/grant programs available. However, make sure to check out the current federal contractor funding options.
A federal program is stringent upon annual refunding payments. Meaning that your project will have to compete in the pool market to be accepted for funding.
If you miss funding round, you will be stun-locked from applying for a whole year, putting your project at risk of non-completion.To acquire federal funding – you will be required to hire a specialist, further advancing your soft costs for your project plan.
Contractor Funding – The Right Way
Now that we have covered all of the necessary information, in regards to contractor funding – you are more than capable of financing your next large construction project, armed with new understanding and tools for growth.
In the end, there really is no right way to go about construction financing. All of the options are solvent and can help you in a myriad of ways. Whichever you choose for your project – will be the one that shall serve you most.
So don’t hesitate – write your basic construction plan, figure out your finances and get that loan. Happy building!