The worst thing that can happen during a construction project is to run out of money before your project is complete. In the banking industry, this is referred to as the project being “upside-down” the result of unforeseen cost overruns, resulting in a lack of funds to cover project costs.
All this can be avoided by performing a feasibility study before going to the bank for commercial real estate financing. This important exercise, along with a detailed construction budget, specifications and construction plans, assures your banker that the project is viable.
“No borrower should enter into a construction project not knowing what the bottom-line numbers are going to be,” says Dave Simko, vice president, commercial real estate, Huntington Bank, Akron.
Feasibility tests and planning are critical to understanding whether the venture is a wise undertaking. “You want to be sure the project makes good economic sense,” he adds.
Smart Business spoke with Simko about various commercial real estate loans and how you can help streamline the underwriting process.
When does a developer/business need a commercial real estate loan versus a business loan for project financing?
A commercial real estate loan is appropriate for large projects, generally $5 million or more, which usually involve more complex requirements. Smaller transactions are often handled through a business-banking lender. As far as commercial real estate/construction loans, those are used to build shopping centers, office buildings or residential developments. Commercial real estate lending requires unique underwriting, structure, approval and administrative processes as it relates to acquisition, construction and development loans.
How do the three types of commercial real estate loans differ?
Acquisition loans include the purchase of raw land or owner-occupied and investment properties with existing improvements. They also may include funds identified for renovation. It is advisable to have a building condition analysis completed prior to closing an acquisition loan. This analysis is separate from the property appraisal and environmental Phase 1 study and describes building conditions, identifies deficiencies and includes a budget for immediate and long-term corrective actions.
Construction loans include funds identified for construction, whether new construction, expansion or renovation. References to loan amounts are for construction costs only and do not include acquisition costs, soft costs and finance [interest] costs.
Finally, a development loan provides infrastructure improvements to raw land for future development, such as in residential neighborhood developments. This would include bringing all the utilities [i.e. water, sewer and gas] to the project site as well as the construction of streets. Usually, this type of loan is done in conjunction with an acquisition loan. Commonly referred to in the industry as an ‘A&D Loan.’
What is the most important document a borrower can provide to a banker?
The biggest risk any bank takes when granting commercial real estate construction financing is ensuring that there are adequate funds to complete the project. To prevent projects from potentially becoming ‘upside-down,’ you must do your due diligence. This process starts with a feasibility study. This gives the borrower, the contractor and the bank an overall indication as to the viability of a project. The study will take into account location, area demographics, if there are similar projects in the general area, potential lease-up and the projected revenue stream. This should be the first step the borrower takes when considering a project.
Feasibility studies can range from a few pages long to a book-length document, depending on the size and complexity of the construction project. You can’t afford to cut corners. By doing your research and drawing a realistic conclusion of a project’s bottom line, you can avoid potential pitfalls that may jeopardize your project.
What issues do banks confront in commercial real estate construction lending?
Invariably there always seems to be some sort of cost overrun with any project. Sometimes it is because of unforeseen circumstances, changes in building code requirements or changes to the project itself. This becomes an issue when your construction budget did not allow for those contingencies or miscellaneous items, or the percentage allowed for such line items was insufficient. Those percentages usually range between 3 to 10 percent of construction costs depending, again, on the size of the project.
The key is to partner with a banker who can assist and educate you during the lending process. Banks can provide contacts for real estate research firms and construction consultants who can assemble feasibility studies. Don’t leave any stone unturned when you are going through the budgeting process. Your project’s success depends on your preparation.
DAVE SIMKO is vice president, commercial real estate for Huntington Bank in Akron, Ohio. Reach him at David.Simko@Huntington.com or (330) 835-9552.