Commercial Construction Loans: The Complete Guide

Commercial construction loans are not structured like traditional loans. Unlike loans you may be more familiar with, you will not receive the full loan amount as a lump sum and pay it off plus interest over time.

Commercial construction loan distribution differs from standard loans and includes the following unique aspects:

• Draw Schedule: The lender and borrower work together to create a plan for the loan to be distributed over the course of the project. As milestones are reached, partial amounts of the loan will be dispersed to the borrower. Ex: The first draw from the loan will be used for clearing and developing the land. The next might happen when the foundation is poured, the building is framed, and so on.
• Inspectors: Lenders typically require an inspector to confirm that the work is completed at each milestone before releasing the next partial amount of the loan. This process will continue until the full amount of the loan has been distributed.
• Interest: You only pay interest on the portion of the loan proceeds you’ve received. If the total cost of your new construction or renovation is $500,000, but the lender has only given you $100,000, you will only owe interest on $100,000.

Other commercial construction loans like the Small Business Administration CDC/504 loan provide more long-term options, so an additional loan following the completion of the project will not be needed.

For commercial construction loans, borrowers should expect to pay interest rates between 5% and 18%.

The rate you end up with will depend, as always, on your credit score and lender. Traditional banks will typically offer the lowest interest rates while hard cash lenders tend to be higher.

Like any loan, you’re most likely going to encounter fees with a commercial construction loan. The fees below are not unique to these kinds of loan but are still important to keep in mind when you’re factoring the final cost of any loan.

You may encounter:

• Guarantee Fees
• Processing Fees
• Documentation Fees
• Project review Fees
• Fund control Fees

Learn more about common fees lenders may charge in addition to interest rates on a loan.

Because commercial construction loans are considered high-risk, most lenders are going to require a down payment.

A down payment takes some of the risk away from the lender and is typically between 10% and 30% of the total project cost.

It is rare for a lender to cover 100% of the cost of a construction project.

Typical lenders will use the loan-to-cost calculation for commercial construction loans. The equation for this ratio is the total amount of the loan requested divided by the total project cost. Here is an example:

A business requests a loan of $190,000 for a project that costs a total of $200,000

$190,000 / $200,000 = 0.95 and expressed a percentage the loan-to-cost ratio for this project would be 95%

Requirements vary by lender, but most will require a loan-to-cost ratio of 80% to 85%.

Following the example above, the lender would loan between $160,000 and $170,000.

What does a borrower do if a lender will only partially fund their project? The rest of the cost may need to come from their own pocket, but there are some other options, like mezzanine loans, which we’ll discuss later on.

The Small Business Administration (SBA) CDC/504 loan is one of the most popular commercial construction loans.

Borrowers tend to choose these loans over others because of the low down payments, competitive interest rates, and credit score requirements in the high 600s.

With this loan, an SBA-approved Certified Development Company will fund 40% of the costs to renovate existing facilities, build new facilities, or purchase/improve land. Up to $5.5 million is available for borrowers.

Another lender will need to provide 50% of the project costs, while the borrower will be responsible for 10%. In some cases, borrowers may be required to pay 20%. Repayment terms are available for up to 20 years, and interest rates are based on the market rates that the U.S. Treasury issues.

The SBA also has the 7(a) program, which can be used for the purchase or construction of commercial real estate.

Through this program, borrowers can receive up to $5 million with repayment terms of up to 25 years. Interest rates are based on the prime rate plus a maximum of 2.75%. To qualify, borrowers should have a credit score in the high 600s and a down payment of 10% to 20%.

Here are the base rates and markups for a 7(a) loan from the SBA:

Thinking about applying for an SBA 7(a) loan? Check out SmartBiz, one of our favorite mediators of SBA loans:

A traditional commercial construction loan from a bank is another common option for business owners.

Rates, repayment terms, and down payment requirements vary. Generally, a minimum down payment of 10% is required, maximum repayment terms of 25 years are standard, and fixed and variable rates are available.

You can start your lender search by talking to your current financial institution about your financing needs. See our post on the best banks for small business loans if you’re interested in specific recommendations.

As we mentioned earlier when discussing loan-to-cost ratios, mezzanine loans are another option for borrowers looking for a commercial construction loan.

When a loan-to-cost ratio is lower than a borrower needs, and they have to find additional funds, a mezzanine loan might be an option. These types of loans are secured by stocks. If a borrower defaults, the lender can convert to an equity stake.

With a mezzanine loan, the borrower has more leverage and can achieve a loan-to-cost ratio of up to 95%.

Your application process is going to look different based on what kind of loan you end up applying for, but the first step is always going to be finding a lender.

• SBA-Approved Intermediary Lenders: These lenders (banks, credit unions, and private lenders) distribute 7(a) loans.
• SBA-approved nonprofit CDCs: Community development corporations provide funding for CDC/504 loans.
• Banks & Credit Unions: These institutions offer every kind of loan we’ve discussed above. Check out our article on applying for a loan through a credit union if you’re unfamiliar with the process.
• Hard Money Lenders: These are private money lenders that provide short-term funding options for commercial construction projects. These loans typically come with higher interest rates and fees.

Once you have a lender, you’ll begin the application process! This is when the lender will begin evaluating your personal and business financials, your credit score, and other factors that will determine whether you get approved for a loan and what your interest rates/terms will be.

Here are several things potential lenders will consider when you apply:

• Your credit score
• Your business’s credit score
• Your Debt-To-Income ratio (DTI)
• Your Debt Service Coverage Ratio (DSCR)

Your lender will also look at your industry experience and current business financials.

Commercial construction loans are considered high-risk, so you’re going to need to prepare yourself to provide documentation to prove that you’re a smart investment for a lender.

You’ll need to provide the following:

• Detailed Business Plan: This needs to include an overview of what your business does, its financials to date, details about your current operations, and your future projections. In some cases, this plan will need to be altered due to risks spotted by the lender. Make sure you’re flexible!
• Project Details: It probably goes without saying that you’re going to need to provide your lender with detailed plans for your project. This includes, but is not limited to, project specs, designs/blueprints, and an expected project cost which includes estimates for contractors, materials, and other expenses.
• Personal & Business Financial Documents: This is probably another group of materials that you expected to see on this list. Prepare your personal and business tax returns, profit and loss statements, balance sheets, bank statements, income statements, and debt schedules showing current debt obligations.
• Credit Score: While this technically isn’t something you provide, you do need to keep in mind that lenders are going to pull your credit score during the process. Remember that they’re looking for scores in the high 600s. Negative items like bankruptcies, foreclosures, and past defaults on loans may automatically disqualify you from receiving a loan or require an explanation to the lender.

Remember, different lenders may require more or less than this list.

Lenders are going to take a minimum of several weeks to go over your information because commercial construction loans are such a high-risk product. They may require more documentation or have other questions for you during this time, so check your email and answer phone calls while you’re waiting to hear about the decision.

Congratulations! You got approved for a loan!

Now it’s time to move into the closing process. This includes going over the loan agreement, which will have all dates and milestones you’re required to meet throughout the process in order to keep receiving your funds.

Once the paperwork is signed and the closing process is complete, you’ll be on your way to expanding your business!

Commercial construction loans work on a “draw schedule” meaning your funds are dispersed whenever agreed-upon milestones are met. You also only pay interest on the funds that have been dispersed, not the total loan amount.

Any business that meets the eligibility requirements set forth by a lender is eligible for a commercial construction loan. Eligibility requirements vary depending on the lender and the loan size you seek.

Requirements vary by lender, but most will require a loan-to-cost ratio of 80% to 85%.