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
[email protected] or (330) 835-9552.
