Construction loans

Most construction lenders require the sponsor's equity to be invested before the first loan draw is funded. Each draw request is checked against the budget and the work in place, usually by a construction consultant the lender engages. A share of each payment to the contractor is commonly held back as retainage and released as the work, or a given trade's portion of it, is substantially complete.

The budget usually includes an interest reserve funded from loan proceeds, so interest during construction is paid from the loan rather than from the sponsor's own cash. During lease-up, lenders often require property income to be applied to interest first, with the reserve covering any shortfall. If the reserve runs short, the sponsor is typically required to fund the difference.

Lenders also typically require guaranties from the sponsor or its principals: a completion guaranty that the project will be finished lien-free and that cost overruns will be paid, and often a carry guaranty covering interest, taxes, insurance and other operating costs until the property is stabilized. Many loans, particularly from banks, also include a repayment guaranty of all or part of the loan, which is often negotiated to step down as the property reaches agreed leasing or income levels.

A construction-to-permanent loan typically converts into a term loan once the property is complete and meets the lender's conversion conditions, which commonly include occupancy or debt service coverage tests, so a separate refinancing may not be needed. Where the two are financed separately, the construction loan is commonly repaid with a bridge loan if the property is still leasing up, or with a permanent loan once it is stabilized. A sale is another common exit.