How Do I Obtain a Construction Loan?
When developing property, one of the first questions tends to be: “What are we going to build?” The next thought is likely: “How will we pay for it?” It happens to all of us: We want to build something, and we need a way to pay for it - financing. While there are many (many) ways to finance, the traditional structure is through a construction loan and equity.
Lucky for you, there are commercial lenders at almost every lending institution who want to provide a construction loan for your project. While they won’t just give it to you, there is a process and system of requesting these loans. And that’s what we're here to break down for you today.
After we start spending the lender’s money, we need to be able to repay the loan. Based on the loan terms, we will pay monthly P&I – just like on a home mortgage. Let's break down this second Big Question.
The simple answer: through cash flow the property generates.
The complex answer: how the cash flow is generated.
Typical cash flow is created through a lease structure. We lease the space to a tenant. They pay us monthly, weekly, or nightly rent (depending on the kind of property). This revenue is not all profit – there are operating expenses. After all operating expenses, we have a Net Operating Income (NOI). The NOI is what a lender will look at to understand the Debt Service Coverage Ratio (DSCR). Each lender has a DSCR they like to see. Typical is 1.25.
This means the lender expects the property’s monthly P&I payment to be at a maximum of 80% of NOI. For example, if a monthly loan payment is $1,000, then the property’s NOI needs to be $1,250. This payment is 80% of the NOI.
The easiest way to communicate this to a lender is to create an Income Statement. The income statement is a 10-year projection of revenues, expenses, and net operating incomes.
Now, how do you create an income statement?
A note for the new: The best way to organize this data is to utilize a Pro Forma. The basics of a pro forma are:
Amortization Schedule (for calculating P&I based on the size of loan)
Sources & Uses
Financial Returns (if you’re interested in calculating returns)
Create this pro forma in Excel – or any tool that manages calculations and allows you to create a workbook with multiple tabs.
Scope, Schedule, & Budget
The basics of every project are within these three categories. We need to be able to communicate what our project will be and knowing the details of these three things will get you from start to finish.
Scope: Building a Rent Roll
The basics of scope:
Product Type: Residential, commercial, retail, multifamily, hospitality, senior living, office
Number of units
Rentable Square footage
For example, if you’re building an office building:
Number of Units: 4
Total Rentable Square Footage: 20,000
Revenue Driver: Lease, $15 per square foot
In this scenario, let’s assume 3 of the offices (15,000) get leased at $15 per square foot. Annual revenue is 15,000 x $15 = $225,000.
Knowing your scope means knowing what you’re building and how it creates revenue. They inform each other.
When creating an income statement, my first step is to create a Rent Roll. The rent roll is a way to document all of my scope assumptions (unit count, square footage, and projected rents).
Once you have your rent roll, you can set up the income statement.
Once you have your income statement, you calculate your NOI.
Once you have your NOI, you can begin calculating your DSCR.
To calculate your DSCR, you need an amortization schedule. This will tell you what your monthly P&I is based on what size of the loan.
While we’re not going to map out how to build an Amortization Schedule here, we will tell you what you need to do:
Research how to create one and then create it in your pro forma
Debt Terms Assumptions
Amortization Period (15, 20, 25, 30 years)
Calculate monthly & annual payment
Link the annual payment to your income statement on a row below the NOI – title this row Debt Service.
Once you have a tool that tells you the annual P&I and this is linked to your income statement, you can create another row below your Debt Service. Title this row DSCR and set up a formula to divide NOI by Debt Service. (Example: $1,250 / $1,000 = 1.25.)
Budget: Sources & Uses
The moment you’ve been waiting for: How much can you spend?
Lenders have a magic statement: They will provide the lesser of 80% loan to cost of the loan to value.
Development 101: The cost should always be less than the value. In short, the lender is telling you, they will give you 80% of the cost.
Let’s use the office example again. If the revenue is $225,000 per year, let’s assume the expenses are $50,000. The NOI is then $175,000. At a 1.25 DSCR, the property could afford to pay $140,000 in debt service. ($175,000 / 1.25 = $140,000.)
In your Amortization Schedule, start plugging loan sizes into your terms to calculate what annual P&I is equal to roughly $140,000. In a 25-year amortization at 3.75% interest, the loan size would be roughly $2,250,000.
If that is the case, then we can understand the following:
Loan Size is $2,250,000
Loan to Cost is 80%.
$2,250,000 / 80% = $2,812,500
What does that mean? That means you could spend $2,812,500 on the whole project. The lender will give you up to $2,250,000. The balance of the project is paid with equity – $562,500 (20%).
Once you understand how you’ll pay (sources), the balance is to map out how you’ll spend it (uses).
Packaging it All Up
While there is a lot of information to understand here, there are two key things I want to ensure you take away:
The importance of having a tool to calculate and manage all of this data
The importance of defining your scope
With that tool and data, you can organize a Pro Forma that a lender will be able to review to understand how much you need and how it will be repaid.
I like to cut and paste tables from my Excel Pro Forma into a 6-page PowerPoint presentation – I add a little narrative at the beginning. Export as a PDF, and get the conversation started.
We understand this is a lot to unpack. Need to know where to start? We’d suggest you get in touch with the SHYFT team to help you with your scope. This is a foundational element that will take your project from an idea into a Pro Forma.
From there, it’s finding the right partners to help finance your project.