Comprehensive Guide to Construction Loans by Development Finance Partners
Since 2011, Development Finance Partners has answered thousands of questions about construction loans. We’ve distilled our extensive experience into this comprehensive white paper to provide you with a deep understanding of construction loans. This guide will equip you with the knowledge to confidently navigate the complexities of construction financing, addressing common questions and offering clear definitions of industry terms.
What is a Construction Loan?
A construction loan is a specialised, short-term financing option tailored to cover the costs of building or renovating residential or commercial properties. Unlike traditional mortgages, which provide a lump sum for purchasing existing properties, construction loans disburse funds incrementally as the project progresses. Financiers rely on quantity surveyors to verify expenses, ensuring that funds are used appropriately and the project stays on track. This process is essential for mitigating risks, maintaining budget control, and protecting the interests of both the lender and borrower.
How Much Equity Do You Need?
The equity contribution required for a construction loan depends largely on the Loan-to-Value Ratios (LVR). Understanding the different types of LVRs is key to planning your project financing.
Loan-to-On Completion Value Ratio (LVR On Completion or Loan to GRV)
This ratio is calculated by dividing the approved loan limit by the value of the completed assets once the project is finished. For example, if the completed value of 20 residential townhouses is $10,000,000 (net of GST) and the LVR On Comp is 65%, the loan amount would be $6,500,000.
Loan-to-Total Development Cost Ratio (LTC or LTDCR Ratio)
The LTC ratio measures the proportion of the total project cost that is financed through a construction loan. It’s calculated by dividing the loan amount by the total project cost. For instance, if the total development cost is $8,000,000 and the loan amount is $6,400,000, the LTC ratio would be 80%.
Typically, financiers will choose the LVR that results in a higher cash equity contribution from the borrower.
How Many Presales Do You Need?
The number of presales required for a construction loan can vary significantly depending on the lender, project type, market conditions, and the developer’s track record.
- Banks typically require 70%-80% of units to be presold.
- Non-bank lenders, however, may require as little as 0%-30%.
Several factors influence presale requirements, including the size of the project, current market conditions, and the experience of the developer.
Interest Rates and Fees for Construction Loans
Construction loan costs can vary widely based on the lender and the type of loan you secure. Typically, banks offer lower interest rates and fees due to the lower risk associated with their loans, while non-bank lenders often cater to higher risk profiles, which can result in higher costs. Here’s a general comparison:
Attribute | Bank | Non-Bank |
|---|---|---|
Interest Rate | Cash Rate + 1.75% | Cash Rate + 4% |
Line Fee | 1.5% | 2% |
Lender's Establishment Fee | 0.5% | 1.5% |
Presales Hurdle | 80% | 0% - 30% |
LVR On Completion (LVR On Comp) | 65% | 70% |
LVR Loan to Cost | 75% | 85% |
Understanding Exit Strategies for Construction Loans
A key component of construction loan management is planning your exit strategy. The most common exit strategy involves selling the newly constructed property, with the net sale proceeds used to repay the loan. For commercial projects, a combination of selling and refinancing may be necessary. Additionally, many developers opt for interest capitalisation, where accrued interest is added to the loan principal during construction, easing cash flow concerns and eliminating the need to demonstrate serviceability during the project.
Line Fees in Construction Loans: What You Need to Know
Line fees are charges applied to the entire loan facility, not just the amount drawn. These fees can significantly increase overall costs, particularly if there are delays in the project timeline. When possible, selecting a lender with lower or no line fees can help reduce your financing expenses.
Strategies to Reduce Cash Equity Contributions
To reduce cash equity contributions, developers often employ various strategies such as:
- Soft Equity Uplift: Leveraging increases in property value during development.
- Senior Debt: Using a primary loan for a larger portion of project costs.
- Joint Ventures: Partnering with other developers or financiers.
- Mezzanine Financing: Adding a secondary loan that bridges funding gaps.
- Phased Development: Breaking the project into smaller stages.
- Refinancing Existing Assets: Freeing up capital by refinancing properties you already own.
Each of these strategies can help improve loan terms, reduce cash requirements, or provide greater flexibility in project financing.
What is a Residual Stock Loan?
Residual stock loans allow developers to retain unsold units post-construction without the immediate pressure to sell. These loans refinance existing construction loans into short-term loans secured against the unsold units. This provides flexibility in managing inventory and optimising returns on investment.
Types of Construction Loans Available
- Bank Loans: Ideal for projects with low risk, low cost and high presales.
- Non-Bank Senior Loans (>$25m): Suitable for SME developers with larger projects needing fast approvals, low presales/recommits and low equity contributions.
- Non-Bank Senior Loans (<$25m): Ideal for SME developers prioritising low equity contributions, no presales/recommits but requiring a slower approval process.
- Preferred Equity & Mezzanine Financing: Ideal for filling funding gaps, though it involves higher risks and higher returns.
- Stretch Senior Financing: Offers a higher loan-to-value (LTV) ratio, combining elements of senior debt and mezzanine financing.
Choosing the Right Construction Loan
Selecting the right construction loan depends on your priorities—whether it's minimising interest rates, reducing equity contributions, limiting presale conditions, or achieving faster approvals. Tailoring your loan choice to your development strategy and resources is crucial for project success.