Rarely will a real estate project be funded solely with owner/investor cash. This may be wise in certain instances, yet not often. For properties that will generate cash flow, leverage helps to lower the cost of capital and boost investment returns. Beyond vanilla mortgages for stabilized properties, construction financing introduces additional complexities.
Banks and credit unions are the most obvious source of construction financing. Most banks have loan officers that specialize in real estate construction, or may even have an entire division dedicated to those types of loans. This is specialized lending because of the monitoring and coordination that is required to make sure that the project is completed with the total funds available.
Common Construction Loan Requirements
Most construction lenders will have a laundry list of requirements that REPE beginners may not have any experience with. Below is a list of the common requirements for construction loans.
Monthly Draw Requests using Standardized AIA Forms
A draw request is a written request by the General Contractor for payment in accordance with the project budget. Typically draw requests are completed using standardized AIA forms (American Institute of Architects). The draw request form and supporting schedules provide great detail of the costs for the work that has been completed to date, or the cost of materials delivered to the construction site. Normally the General Contractor, the project Architect, and the Owner sign the draw request before delivering it to the lender.
Construction Progress Inspections
Progress inspections are usually performed by an independent inspection or engineering firm. These inspections verify that the work actually completed is commensurate with the draw request as of that date. Normally a draw request will not be funded without such an inspection. Bankers are not experts in construction, therefore an independent verification that the draw request is appropriate ensures that the funds are being expended appropriately.
Title Company Funding
Because the dollars involved are usually significant, a third party is often desirable to handle the payments to the General Contractor and subcontractors. A title company will ensure that contractors and subcontractors are paid, avoiding the risk of a mechanic’s lien being filed against the project. A mechanic’s lien is a guarantee of payment for work completed or materials provided. A mechanic’s lien filed against the property may be enforceable ahead of the lender’s mortgage.
In exchange for payment each month, contractors are asked to sign a lien waiver. Lien waivers acknowledge that the contractor has been paid and that there is nothing outstanding that would cause the contractor to file a mechanic’s lien. Lenders will not accept a new draw request until all of the lien waivers associated with the prior draw request have been received.
Loan Balancing and Change Orders
As construction progresses, there are usually changes that must be made. Changes to the construction contract are called change orders, and they may either increase or decrease the cost of the project. Tracking these change orders and keeping the loan in balance is critical to ensure that there are sufficient funds available to complete the project. If change orders result in a higher project cost, the owner will likely have to inject additional capital in order to finish construction.
Retainage helps to ensure the contractor finishes 100% of their work. Most construction contracts will include retainage, and lenders usually require this as well. The construction contract will state the retainage as a percentage, normally between five and ten percent. With each draw request, the retainage percentage is NOT paid to the General Contractor or to the subcontractors, creating a type of reserve account. These funds are not paid out until the very end of the project, usually after the certificate of occupancy is issued by the municipality. The retainage incentivizes the contractor to finish their work to obtain their full payment.
Real estate construction and redevelopment represent significant opportunities for REPE firms to create value for their funds. Having a basic understanding of the leverage available for these projects is crucial in the advancement of your career.