Breaking Down the Construction Loan ProcessFeb 16, 2021
People always want to know about construction loans... what it's going to be like... can they go get their own... There are a lot of questions that revolve around this topic so we're going to go through each of them in this post.
Among the topics covered,
- What is the construction loan going to look like?
- Can I get my own or not?
- Explaining interest rates and prime plus one
- Are construction loans expensive?
- Breaking down payments
- 12-month timeframes
- Is it easier to get a construction loan than a 30-yr fixed?
- What if the builder takes longer than the contract period?
- Incentives/penalties for the builder to finish on time
- Has FIG changed their construction loan process since FIG has been in business?
Can you get your own construction loan?
I hate to give such a wishy-washy answer, but 'maybe, kind of, probably'. Is that specific enough? The challenge is, we're talking about a construction loan on a multifamily asset. It's not just any bank that is going to be willing to do that. We've usually found that it's small community, local, regional banks, and credit unions that are willing to issue construction loans on multifamily property.
Now, here's the challenge. Anytime you do that, we're dealing with attached units here. So we might have, for example, eight townhouses in a row that's platted as two fourplexes. There's a big advantage in having the same construction lender on those because you can't begin construction on Unit A unless you know that Unit B has already closed or will be closing soon.
So guess what happens when you bring in another lender off the street that nobody knows and we haven't vetted? We're not sure if they can actually close or not. You can get in a bad position where Unit A has closed, but can't start construction, because Unit B has a lender that's just not working out...
So we're watching for that constantly. There are specific banks that we have paired into these projects, and that makes people always wonder, am I getting ripped off? Am I paying too much money for my construction loan? Sometimes at a quick glance at the terms of a construction loan, they might think that because they're inadvertently comparing it to a 30-year fixed-rate loan. It's not the same thing.
Construction loans usually have rates of "prime plus one". Whatever the prime rate is, plus a percentage. Maybe prime plus one and a half... This is the interest rate on a construction loan. It's not the same rate as the Quicken loan guy on TV, or whatever rate you heard from a loan broker most recently.
Right now as I record this, interest rates are around 5-5.5%. That's prime plus one right now. The biggest component is that construction loans are interest only and they're typically for a set period of time (usually a year).
When we talk about a loan amortizing that means every payment you make, you're paying down the principal. You don't do that on a construction loan, it's just straight interest for a year and when that year is up, you've got to pay the construction loan off. Most of our investors do that with a refinance into a 30-year fixed-rate mortgage.
Are construction loans expensive?
You got to remember, it's a highly specialized product. It's not something you can just call up Wells Fargo or whoever and say, will you do this loan? You're looking at an origination of a percent or so.
When you close on your construction loan, that's when you make your down payment (your 25% down). You're also going to pre-pay interest reserves. The lender doesn't want to have to track you down for a check every month for what you've drawn out of the construction loan. Instead, they put those interest reserves when you close in an account. Every month as the builder draws against your construction loan, the corresponding amount of interest is debited from that account.
Usually what we see is when somebody closes on a fourplex, they've got about $34k. in what we call "buying costs". This includes title fees, attorney fees, appraisal, HOA set up... all the typical closing costs that you're used to in a normal transaction. $34k sounds pretty thick, but that's because it's got that interest for a full year baked into the cake.
What you'll see on a construction loan is that during the 12-month contract to build your fourplex, you will get like seven or eight different draw requests. These come over as a DocuSign from the construction team at FIG. It's going to say "please sign this draw request for $50k". This is for your permit, foundation, footings, underground plumbing, etc. Once you sign that the construction team doesn't just get the money. The bank doesn't want to pay any draws out for loans and deals that have not been constructed. They're going to send an inspector out to the job site to confirm that yes, permit, foundation, footing, plumbing, is done.
Once the inspector independently confirms that yes, those things have been done. Then and only then is the builder paid for that portion of the fourplex budget. So at the end of the month, your construction loan balance that was previously zero is now 50,000. And then they're going to take that interest rate of, let's say 5%, multiply it by 50k, and divide by 12. That amount is what gets debited from your interest reserve for the month.
So you can see, at the beginning of the construction process, your interest payments are very small. As we progress and the builder draws down more on that construction loan, those payments get bigger. The construction lenders know that and calculate them so they're not having to beg you for more money at the end, or you're not having to put more money in. Nobody wants that. It's streamlined so that there is an adequate interest reserve in place.
Then when you're done you refinance out of it and go into you're long-term, 30-year fixed-rate. This is where the savings are. Where you're usually going to see a rate that's lower than wherever construction loans are at the time.
Bottom line: Construction loans are for a year, they're interest only, and the rate is a little bit higher than what you'll see on a 30-year fixed loan. But that's normal because all banks do construction loans, typically on a prime plus a set percentage.
Is it easier to get a construction loan than a 30-year fixed-rate loan?
Not really. You generally have to be a little bit better qualified to get a construction loan. However, if you've got adequate credit, you've got the downpayment funds, then if you qualify for one, you qualify for the other.
Ironically, the way you qualify for construction loans on a FIG deal, for example, is that you get pre-qualified with our preferred long-term lender. Our long-term lender is going to do the typical mortgage approval with you that you may have been through before... assembling tax returns, bank statements, W-2's... They're going to take your pre-qualification to one of the construction lenders we use in the market where the property will be built. Then that lender approves you for the construction loan based on our pre-qualification. They know you are good to pay it off because our long-term guy has already approved you for a 30-year fixed-rate loan.
If you have a decent FICO score and you have the down payment, you're probably going to qualify. Of course, we'd need to get you with the lender to determine that for sure.
What happens if the builder takes too long on my fourplex or my duplex?
Let's first quantify what too long actually means. When you sign a purchase agreement on a FIG deal, that is a 12-month purchase contract unless the contract says otherwise (I can't think of a time where it's ever not been 12 months). Twelve months is about what it takes to put one of these things together front and back.
In a perfect world. You could build a fourplex in six months. However, construction, especially in 2021 is not perfect. You need time for uncertainties and curveballs that come up. Twelve months is the contractual timeframe.
What happens, people get concerned that they've got this construction loan and it's budgeted for 12 months worth of interest. What if it takes too long? We want the builder team to be incentivized to complete these on time. If the builder takes longer than 12 months to get you your final certificate of occupancy, then they're going to owe you a penalty of $500/door per month. That's what happens.
Guess what? The construction lender isn't going to care if you say, "well FIG said it was going to be 12 months!". You have a note with the construction lender that you've got to pay. So what happens, in this case, is the investor ends up having to pay a little extra interest to the construction lender. But at the same time, they've got $500/door per month, coming back to them.
Is that enough to cover all of it? This is something we get asked often. There's no way to know for sure. It's close. Sometimes it's a little more, sometimes it's a little less. But generally, the builder is only going to go over 30-60 days tops. And that doesn't happen very often. They usually deliver successfully within 12 months.
So that's a good way to think about whether the builder takes too long. There's a penalty in place to make sure they're heavily incentivized to make sure they don't take too long.
Even rarer, what if a builder takes shorter than 12 months? It could happen. If you have some money left in your interest reserve account, by the time you do your refinance, then that money is going to be coming back to you. As you know, in the world of construction, things tend to take a little longer, not a little shorter, in most cases.
Have we changed our construction loan process in the time that FIG has been in business?
Yes, we have. It used to be that we'd cover whatever costs you have above and beyond the 12 months, instead of a set amount. That can get crazy because you can get into a big dispute about what costs you actually have versus what you should have. We don't really have control over what end financing an investor goes and does.
If they come to us and say they have some cost... well, we don't know what they did. So we have that flat penalty that happens every single month, over the 12 months on a construction loan. That's one change that has been made.
Another change we have made is that we now declare units done when they have a certificate of occupancy and when they're actually done. We've learned it's a little shocking how soon a city can give us a certificate of occupancy. They'll walk through a development and say, yeah, a human can live here. That's technically what a certificate of occupancy means. But outside, there could be rebar sticking out of the ground, mud everywhere, chunks of concrete... it's might not be ready for tenants. That's what you're counting on. That's what matters to you as an investor.
There's a difference between a certificate of occupancy and "rent ready". Sometimes we're guilty of using those terms interchangeably. So if you're talking to one of us, make sure you get a clarification on whether things are leaning toward a certificate of occupancy by the book, or are full-on rent-ready where tenants can move in. That's something that's really important to distinguish.