Construction or development loans are types of financial products to be used to build a new property or to develop existing properties.
As with any financial products, there are risks to the lender however these are amplified where first-time developers are concerned and therefore sometimes new developers can find it tricky to obtain finance to commence new projects.
Even experienced developers can sometimes face challenges when securing finances for projects depending on a range of factors linked to the project, personal circumstances or the market conditions.
What is a Construction Loan and what are the application criteria?
Construction or development loans are short term, secured lending products that have been created for the purpose of funding the development of the property. The type of property can include residential houses, commercial property or industrial buildings.
Should the borrowing be required for the initial purchase of the site or plot, the maximum amount that can be loaned is typically between 50%-60% of the purchase price of the property.
Sometimes lending of up to 100% of the build costs can also be applied for, providing that the total amount requested is within 60-70% of the gross development value.
The application process for development finance will usually vary between lenders and requests are often analysed on a case by case basis. The lender would need to review the business plan of the development including the estimated costs including the stages at which the funding is required to be released.
The lender will also require information on the applicant’s personal circumstances, financial background and experience within the building and construction industry.
The lender would analyse all of the information provided within the application and undertake the usual background and credit checks as required when applying for any financial product.
The application process can involve ongoing requests for additional information throughout the analysis phase and therefore can become a lengthy, complex and time-consuming process. Developers often find using a financial broker beneficial as the broker can provide assistance with the application, which is sometimes known as loan packaging.
If an application is successful, an agreement in principle can be issued.
At this stage, further investigations are undertaken including a site visit to ensure project viability and an independent valuation of the project is forecast. Should the findings of these investigations be sufficient, a formal loan offer and terms can be issued.
The legal process would then take place for both parties, followed by the completion of the loan and the first drawdown payment.
Read our related quick help guides:
- Bridging loans for property development.
- A guide to bridging loans brokers.
- Bridging loan examples.
- Alternatives to bridging loans.
- Development finance.
- Construction loans.
What is loan packaging?
As briefly mentioned, the assistance that an expert financial broker can provide during the application process of a construction loan is known as loan packaging. This process will include ensuring that the lender has sufficient information to make a decision on the borrowing request, which will often include a business plan and timeline of the proposed project summarising:
- The purchase costs of the land plot and or current building.
- The detailed costs of the building work to be undertaken during the development project.
- Detailing all of the additional costs that will be required throughout the project such as; finance costs including interest, exit fees and any broker or arrangement fees, the costs of insurance, costs of paying any utilities or council tax during the project plus any professional fees for advice or services.
- Full disclosure of any possible legal issues that may arise during the project.
- A thoroughly costed exit plan advising how the financing will be settled at the end of the term of loan. Often an exit strategy involves either the sale of the property or refinancing.
The process may require regular communication between the lender and applicant representative while the lenders undertake thorough due diligence of the applicant and project itself. Therefore, the use of a specialised broker to manage the progress and respond to queries directly is highly recommended.
How does a Construction Loan work once approved?
Following an offer from a lender, the finances will be released at set stages throughout the project. The duration of the stages will be agreed in advance and will depend on the type of project itself, however, they could be for example:
- Stage 1 – Purchase of the land or existing property.
- Stage 2 – The development stage, which would often be split down further into stages depending on the nature of the building project.
- Stage 3 – Sale of the property and settlement of the construction loan.
The number of drawings from the total loan value would be agreed upon upfront and also have an agreed schedule to match the planned programme of works.
There will be some degree of flexibility in the duration of the stages, especially as even the best-made plans can easily go off the rails during the project due to external elements such as the weather or materials or labour resourcing issues.
However, the overall maximum duration of the loan will be set out within the application and lender’s offer.
What are the Advantages of Construction loans?
The main benefit of a construction loan is that it allows borrowers to have access to larger sums of money than traditional borrowing methods.
The flexibility available with this type of finance is also a major benefit to developers, both with the ability to plan and fund the project in stages, but also to provide a method of keeping the costs of borrowing as low as possible. The costs are kept low due to the fact that interest is only charged when monies are drawn.
Construction Loans Summary
Construction finance is a short-term, cost-effective and flexible type of borrowing that is suitable for a range of development projects. Such financial products are rarely found on a typical high street and therefore are usually applied for and accessed via a specialised broker.
Specialised brokers have access to a wider market of financial products and varied specialist lenders and therefore can assist in obtaining the most competitive borrowing terms and interest rests.
As with all secured borrowing, the property and security deposits are at risk should repayments not be made and therefore any investment decisions should be fully considered before committing, along with the consequences should developments not go to plan.
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