How construction loans are structured
Construction loans are typically interest-only, floating-rate facilities sized to a percentage of total project cost (loan-to-cost, or LTC) or completed value (loan-to-value, or LTV). Most ground-up construction lenders size to 60%-75% LTC or 55%-65% LTV, with the lower of the two acting as the binding constraint.
Initial proceeds at closing typically fund the land acquisition (if not already owned), soft costs incurred to date, and a portion of the construction budget. Remaining proceeds are funded through monthly draws against vertical construction progress, with each draw inspected by the lender's construction consultant.
Typical terms and pricing
Construction loan terms typically run 24 to 36 months, with one or more extension options. Pricing is floating-rate over SOFR, with spreads ranging from SOFR + 300 to SOFR + 600 depending on asset class, sponsor track record, and submarket fundamentals. Origination fees typically run 1-2 points; exit fees vary by lender.
Most construction lenders require a completion guarantee from the sponsor (or a creditworthy guarantor), even on non-recourse loans. The completion guarantee ensures the project is built to plan, on budget, and on schedule, and survives the otherwise non-recourse nature of the loan.
What lenders look for in sponsor and project
Construction lenders underwrite both the asset and the sponsor. On the asset side, lenders want detailed plans, a hard-cost GMP or cost-plus contract with a qualified GC, realistic contingency (typically 5-8% of hard costs), and a defensible market study supporting the lease-up assumptions.
On the sponsor side, lenders want demonstrated track record building similar product in similar markets, financial capacity to cover cost overruns and lease-up shortfalls, and a credible permanent debt strategy at completion. First-time developers face higher pricing and lower leverage; experienced sponsors with multiple comparable projects get the best terms.
- Plans and specifications, with civil engineering and architectural sign-off
- GMP construction contract with a qualified general contractor
- Sponsor track record on comparable projects
- Market study supporting absorption and rent assumptions
- Completion guarantee from sponsor or creditworthy guarantor
- Permanent debt strategy or sale plan at completion
Frequently asked questions
- How are construction loan draws funded?
- Construction loan draws are funded monthly against AIA-style draw requests. The lender's construction consultant inspects work in place, confirms completion against the budget and schedule, and authorizes the draw. Funds are typically wired within 5-10 business days of approved draw request.
- Are construction loans non-recourse?
- Many institutional construction loans are non-recourse, but virtually all require a completion guarantee from the sponsor or a creditworthy guarantor. The completion guarantee ensures the project is built to plan, on budget, and on schedule, and survives the otherwise non-recourse nature of the loan.
- What contingency do construction lenders require?
- Most construction lenders require 5%-8% hard cost contingency, with higher requirements for first-time developers or complex projects. Soft cost contingency is typically 5%-10%.
- How does a construction loan convert to permanent debt?
- Most construction loans don't auto-convert, they're paid off at completion through either a sale or a refinance into permanent debt (bank, agency, life company, or CMBS). Sponsors should have the permanent debt strategy mapped out before closing the construction loan.
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