Construction Loans

Construction loans finance building projects from ground-up or major renovation. The lender disburses capital in stages ("draws") as construction milestones are reached. At completion, the loan converts to permanent (amortizing) financing.

Key takeaways

• Construction loans are disbursed in staged draws (25%, 50%, 75%, 100% of budget) tied to construction milestones verified by a lender-hired inspector
• Interest accrues during construction but is paid from an "interest reserve"—funds held back at closing and released in stages as the project completes
• Conversion to permanent financing is contingent on final occupancy, leasing, and appraisal; this creates timing pressure if permanent lender denies takeout
• Construction lenders charge 7–9% rates plus 1.5–2.5% origination fees, and rates are often 100+ bps above permanent financing
• Cost overruns and construction delays are the leading causes of construction loan failure; contingency budgets (10–20% of total cost) are essential

Structure: Draws, Inspections, and Interest Reserves

A construction loan for a $2M apartment building financed at $1.5M works like this:

Closing day:

• Lender disburses: $300k (first draw, 20% of loan)
• Interest reserve: $150k (set aside, released in draws as project completes)
• Borrower receives: $300k, construction begins

Month 3 (foundation complete, 25% of construction done):

• Lender inspector verifies progress
• Lender disburses draw #2: $375k
• Interest reserve releases $37.5k to cover interest due that month
• Borrower has completed 25% of budget and can continue

Month 6 (framing complete, 50% progress):

• Draw #3: $375k
• Interest reserve: $37.5k
• Borrower at 50% of budget

Month 9 (final punch list, 90% progress):

• Draw #4: $375k
• Interest reserve: $37.5k
• Borrower at 90% of budget

Month 12 (project complete, certificate of occupancy issued):

• Final draw: $75k (contingency fund minus inspector holdback)
• Interest reserve exhausted
• Conversion to permanent financing (lender or takeout lender funds permanent loan, replaces construction loan)

Draw Conditions and Lender Inspections

Each draw is conditional on:

1. Lender inspection: A third-party inspector hired by the lender verifies that construction matches the budget and the % complete claimed by the borrower.
2. No liens: The contractor and subs haven't filed mechanics' liens against the property.
3. Insurance: Builder's risk insurance is in place and naming the lender as loss payee.
4. Appraisal support: The appraiser confirms that the work completed aligns with the approved plans.
5. Budget reconciliation: Invoices and payment vouchers show costs aligning with the construction budget.

Lenders hold back 5–10% of each draw ("retainage") until final completion. This incentivizes the contractor to finish on time and correct defects. A $375k draw might release only $337k, with $37.5k held in escrow until final inspection.

Interest Reserves and Cost

The interest reserve is a pool of funds held at closing, released proportionally as construction completes. On a $1.5M loan at 8% annual rate, the construction period is 12 months:

• Total interest for 12 months: $120,000
• Interest reserve at closing: $120,000 (set aside)
• Monthly interest draw: $10,000

The borrower doesn't pay interest in cash during construction. Interest is paid from the reserve. This is critical because a property under construction generates zero rental income; the borrower can't service debt from operations.

If construction extends beyond 12 months, the interest reserve can be exhausted. A 15-month project incurs $150,000 in interest, but only $120,000 was reserved. The borrower must fund the extra $30,000 in interest out-of-pocket or request a reserve increase (the lender may approve, but at a cost).

Over-budgeting the interest reserve is safer. Lenders typically reserve 125–150% of estimated interest to account for delays.

Permanent Financing and Conversion

At construction completion, the construction loan "converts" to permanent financing. The permanent lender (often the same institution, but not always) funds a long-term mortgage (10–30 years, typically 10 years initial fixed rate with balloon).

Conversion is conditional on:

1. Certificate of occupancy: The building is complete and ready for occupancy.
2. Leasing: A minimum percentage of units are leased (typically 70–95% for residential, 60–80% for commercial). Unfinished space is discounted in the appraisal.
3. Appraisal: The permanent lender orders a new appraisal of the completed property, factoring in actual construction costs and current market conditions.
4. Stabilized NOI: The permanent lender underwriting assumes stabilized rental income (usually year 1 or 2 of operations, depending on lease-up speed).

If the permanent lender appraises the completed property at $2.2M but the borrower's basis is $2.4M (land + construction costs), the permanent loan is reduced. If the borrower planned on a $1.5M permanent loan (68% LTV on a $2.2M appraisal), they now qualify for only $1.45M (66% LTV). The shortfall must be covered by borrower equity.

Construction Loan Rates and Fees

Construction loans are expensive because the lender bears construction and market risk.

Rates:

• 7–9% for well-qualified borrowers (strong sponsors, proven developers)
• 8–11% for average borrowers
• 10–13% for weak sponsors or risky projects

Fees:

• Origination: 1.5–2.5% of loan amount ($22,500–37,500 on a $1.5M loan)
• Appraisal: $2,500–5,000 (initial and permanent financing)
• Inspection: $500–1,500 per draw (borrower-paid, 10–12 draws = $5k–18k)
• Permanent takeout fee: 0.75–1.5% (paid if the permanent lender is different)
• Title: $1,500–3,000

All-in cost: 2.5–3.5% of loan amount plus 150+ bps in rate vs. permanent financing.

On a $1.5M construction loan at 8.5% for 12 months + conversion to 6.5% permanent:

• Construction interest: $127,500 (paid from reserve)
• Origination fee: $30,000
• Appraisals/inspections: $10,000
• Conversion fee: $15,000 (1% takeout)
• Total upfront cost: $55,000 + $127,500 interest = $182,500 (12% of loan)

This is expensive relative to a permanent loan (6.5% + 1.5% = $97,500 for year 1), but unavoidable for construction.

Cost Overruns and Contingency

Construction always costs more than budget. Typical overrun rates:

• Well-managed projects: 5–10% overrun
• Average projects: 10–15% overrun
• Poor planning or market conditions: 15–25% overrun

A $2M construction budget for an apartment building should include a contingency reserve of 10–20% ($200k–400k). This reserve covers:

• Unforeseen site conditions (contamination, subsurface obstacles)
• Code compliance additions (new egress requirements, ADA modifications)
• Change orders (client adds scope, contractor adds labor)
• Market-driven inflation (material costs rise during construction)

Conservative developers budget 20% contingency; aggressive developers budget 10%. Lenders typically require 10–15% contingency minimum and hold it separately from the main construction budget.

If you draw the contingency and the project still goes over budget, you must infuse additional equity or request a loan increase (if the lender agrees). This creates execution risk: you might be forced to stop construction or accept incomplete work.

Pre-Leasing and Takeout Commitment

Construction lenders require evidence that the permanent takeout is real. Before breaking ground, you need a "takeout commitment" from a permanent lender: a letter stating they will finance the stabilized property at specified terms (LTV, rate, amortization).

A takeout commitment on a $2M apartment project might state:

Permanent Lender commits to finance the stabilized property upon completion, at terms of 65% LTV, 6.5% fixed rate, 10-year amortization, subject to the property achieving 85% occupancy, an appraised value of ≥$2.0M, and completion of construction per approved plans.

This protects the construction lender: they know the borrower has a path to permanent funding and can exit the construction loan. It also protects the borrower: they know the terms before starting construction.

Changes in market conditions (rates rise, values decline) can create "takeout risk"—the permanent lender won't fund at the promised terms, or the property appraises lower than expected. If rates rise from 6.5% to 8.5%, the permanent lender might offer only 4.5% LTV or 15-year amortization (costing the borrower more). The borrower must either accept worse terms or scramble to refinance.

Sophisticated borrowers negotiate a locked-in takeout commitment with a rate lock. This is more expensive (0.5–1% of loan) but guarantees the permanent rate regardless of market moves.

Conversion Timing and Market Risk

Conversion is supposed to happen immediately upon completion. But complications arise:

Scenario 1 (successful):

• Construction completed month 12
• Certificate of occupancy issued
• Occupancy reaches 85%
• Permanent lender appraises at $2.2M
• Conversion to permanent: $1.43M (65% LTV)
• Construction loan paid off; permanent loan funds

Scenario 2 (market downturn):

• Construction completed month 12
• Occupancy is 70% (lease-up slower than expected)
• Market has declined; appraisal comes in at $1.95M
• Permanent lender wants 1.0x DSCR; project generates $120k NOI ($1.95M × 6.1% cap rate)
• At 1.0x DSCR, max loan = $120k DSCR / $120k NOI = $120k / 0.06 debt service ≈ $2M debt service?

(The DSCR calculation: if NOI is $120k and DSCR is 1.0, then debt service is $120k, which at 6.5% = $1.85M loan.)

• Permanent loan available: $1.85M (not the $2.0M expected)
• Shortfall: $150k
• Borrower must infuse equity or negotiate with construction lender for extension

If the construction lender won't extend and the permanent lender won't fund the full amount, the borrower is in default on the construction loan. This forces a restructure or distressed sale.

Lender Selection for Construction Loans

Dedicated construction lenders (life companies, large banks):

• Specialize in construction + permanent financing (one-stop shop)
• Require strong sponsors and proven projects
• Rates: 7–8.5%
• Best for experienced developers with track record

Regional banks:

• Do construction loans for local developers
• Moderate rates: 8–9%
• More flexible on sponsor strength if project is strong
• Best for mid-size projects ($500k–$5M)

Hard money construction lenders:

• Fast closing (2–4 weeks)
• Higher rates: 10–13%
• Minimal underwriting (focus on collateral, not project quality)
• Best for borrowers who can't qualify elsewhere or need speed

Flowchart: Construction Loan Timeline

Related concepts

• Commercial vs Residential Financing
• Portfolio Loans

Next

Construction loans finance new buildings through staged draws and interest reserves, converting to permanent financing at completion. But what happens when the property is finished, stabilized, and generating strong cash flow? The lender's underwriting shifts from construction feasibility to operating profitability. The metric they care about most is debt service coverage ratio (DSCR)—the property's ability to cover debt payments from its own income. The DSCR landscape varies dramatically by lender; some want 1.5x, others accept 0.75x. Understanding this spectrum is key to accessing affordable capital.