Construction Loans – What You Should Know

The fix-and-flip and fix-and-hold markets are still going strong, but remain competitive to get properties with the right profit margins.  So, to get into a  less competitive space and have the potential for higher profits, many real estate investors who have already gained experience in fix and flips are opting to construct new houses that  could be sold for profit or rented out.

Typical neighborhoods for investors to do “spec” construction (meaning there is no buyer yet, the investor is building and speculating that they will get a buyer at or prior to construction completion) are “infill” areas in already developed areas where land is sparse. So, the investor looks for old homes on good sized lots in “hot” neighborhoods that can be “scraped”. Meaning, the old house will be torn down and rebuilt.

With the right contractor and experience, doing ground up construction may also  be easier than fix-and-flipping, because the investor is not dealing with the unknowns of electrical or plumbing problems lurking behind existing walls or having to retrofit new materials to an old house, or deal with outdated floor plans or floor plans that are not functional.

What Do Construction Loans Cover?

With this type of loan, you can typically expect a shorter term – generally up to a year-, but a higher interest rate.  If you have already purchased the land and own it free and clear, the equity in the land will usually serve as your “down payment” in the project.  If you are seeking to have the land and the construction financed, you will need to have funds available for the down payment.

The construction loan will typically include “soft costs” which are the expenses for plans, permits, soils reports, and architect fees.  Some construction loans may include “interest reserves” for making the loan payment on the loan, but not all do.  The construction loan will also include the “hard costs” of construction. This includes everything for building the project to get a certificate of occupancy, including demolition, framing, appliances, flooring, fixtures, landscaping,  labor, etc.  A 10% to 20% contingency for any overages is also generally required. However, items that are removable, such as furnishings and staging costs are almost never included.

As construction is being completed, construction draws will be done whereby the lender will usually require invoices or receipts for materials purchased and labor paid.  The lender, or their representative, will also inspect the property to determine the percentage of work completed and disburse from the construction account accordingly.  Interest on the construction funds will be charged interest as the funds are being drawn.

What Types of Construction Loans Are Available?

There are different types of construction loans, so it’s best to work with a qualified lender to determine the one that will suit your needs best. Here are two of the main types for real estate investors.

1. Land Purchase with Subsequent Refinance to Construction Loan:

Generally, when real estate investors locate properties in hot neighborhoods to scrape, they don’t have the drawings, plans, or budget in place yet for the new home and they need to close quickly on the purchase of the lot/old home to be scraped.  Architects drawings, plans, and permits often take months to complete, so investors don’t want to waste precious time on a short-term construction loan while they are waiting for these items to be completed.

So, most investors prefer to get a land loan, which they can then refinance into the construction loan when the project is “permit ready”.  The refinance to the construction loan, which is a new one year loan, thus starts the clock over for the construction period.

Generally, depending on the lender, borrowers will put 25 percent down on the lot acquisition. Depending on the total construction cost, the borrower may or may not need to put additional down payment in at the time of the construction refinance.:

2. Construction-Only:

Often times, after an investor has completed several ground up construction projects, they have architect plans and drawings and budgets that can be replicated on future lots. Of course, this depends on the size, configuration, and zoning of the lot.

In this case, the investor/builder may be permit ready much faster and can close on the land acquisition and construction loan at one time versus the two-step process discussed.

Generally, the down payment requirement on investor construction loans is 20 percent,   depending on the lender and “upon completion” appraised values will also need to be met.

Construction Loan vs. Mortgage

To help clear things up, here are some of the ways in which construction loans differ from traditional mortgages:

  • When you take out a mortgage, a lump sum payment is made by the lender to purchase the real estate you want. However, when you get a construction loan, the lender will pay the builder in stages and will check on the progress along the way. Because the construction is completed in increments, payments are made in installments, which are referred to as draws.
  • The reason why construction loan interest rates are higher than the rates for traditional mortgages is because there isn’t any house to use as collateral. Should you default on payments, your lender can’t just seize your real estate, so these loans are deemed riskier. Therefore, you’ll need to meet certain requirements to get this loan, and the lender will want to review not only your finances, but also the builder and the architectural plans you’ve selected.
  • Some of the things you might need to show in order to qualify for this type of loan: a contract with a builder, a schedule for the construction phases through to completion, and a complete and detailed budget.

Finally, keep in mind that not all lenders provide these types of loans, but Merchants Mortgage does. In fact, we offer various types of construction loans, including:

  • Quick Acquisition to Purchase Lot or Lot with House to Scrape with No Construction Funds Committed
  • Refinance of Acquisition Loan to Provide Construction Funds Once Construction Budget and Plans Have Been Completed and Permit Obtained
  • Construction Loan When Borrower Has Already Paid Cash For Lot

Contact us to discuss your options so you can get started on your next real estate project right away!

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