Construction Loans – Commercial Lending Underwriting

Using apartments as an example, let’s take at how your apartment construction loan or commercial construction loan will be underwritten.  The first test will be the Profit Test.  Simply put, after your project is finished will it be worth more than it cost to build?

A related test that is always used in this and almost all commercial real estate lending is the Loan-To-Value Ratio.  After your project is completed and occupied will the construction loan be less than say, 75% loan-to-value (LTV)?  Refer to our article on the explanation of how LTV is calculated.

In today’s market most commercial construction lenders are so eager for a deal that they might even allow up to an 80% LTV.  And if you still need more equity, it is possible that you can qualify for a mezzanine loan.  Apartment construction lenders and commercial construction lenders often will not trust the appraisal, so they will look at the Loan-to-Cost Ratio. (Is you head spinning with ratios yet?)  What is the percentage of total cost of the project is the commercial construction lender being asked to cover?

Looking at history developers were usually asked to cover at least 20% of the total cost of the project, usually in the form of free and clear land.  Not unreasonable to have the developer put some of his own skin in the game, is there?

In today’s environment, however, apartment construction loans and commercial construction loans up to 90% of the cost is possible.  And if the developer needs more leverage, a mezzanine loan is sometimes possible.

The question an underwriter will ask is – will the apartment construction lender or commercial construction lender be able to get out of the deal?  If you are asking for money to build a strip center, will the center pull in enough money to qualify for a takeout loan large enough to pay off the construction loan?

In order to determine if the takeout loan is large enough to pay off the apartment construction loan or the commercial construction loan, your commercial construction lender will figure what the DSCR (Debt Service Ratio Coverage) is.  This ratio shows how much net income will be realized from the project so the commercial construction lender so that there is enough money to pay him/her.  The DSCR usually must be at 1.25 or above.  This means the owner of the project will have 25% more income coming from the property than the payments on the loan so that he/she will be able to pay his/her commercial construction lender or apartment construction lender. 

We will explain the DSCR ration in greater details in other articles.  Stay tuned!

Lastly, the apartment construction lender or commercial construction lender will look to the developer’s new worth.  The rule of thumb is that the developer’s net worth should be as large as the loan amount and many expect the developer’s net worth to be 11/2 times the amount of the loan.  The is called the Net-Worth-to-Size Ratio.  More on that later, too.

So many ratios, so little time!