Definition
A Construction Loan is a short-term loan used to finance the development, ground-up construction, or major renovation of a property.
Unlike permanent financing, funds are disbursed in stages based on construction progress.
How It Works
- Loan is approved based on project budget and projected value.
- Funds are released through a draw schedule.
- Borrower pays interest only on the amount drawn.
- Loan typically matures in 12–36 months.
Key Features
- Interest-Only Payments during construction
- Higher Interest Rates due to increased risk
- Loan-to-Cost (LTC) underwriting metrics
- Inspections & Draw Reviews before funding
Loan-to-Cost (LTC)
Construction loans are often sized based on total project cost:
Loan Amount = Total Project Cost × LTC %
Example: If total cost is $20 million and lender offers 65% LTC, loan amount equals $13 million.
Exit Strategy
- Refinance into permanent (stabilized) loan
- Sell property upon completion
- Convert to long-term hold financing
Why It Matters to Investors
- Higher risk profile than stabilized loans
- Exposure to cost overruns and delays
- Sensitivity to interest rate fluctuations
- Dependent on market absorption at completion
Example
A developer builds a 150-unit apartment project with a $30 million total budget. A lender provides a 70% LTC construction loan. As construction progresses, funds are disbursed monthly after third-party inspection approval.
Common Pitfalls
- Underestimating contingency reserves
- Construction delays
- Interest rate spikes
- Failure to secure take-out financing