How exactly are construction loans profitable?

teddythebear's picture
Rank: Neanderthal | 2,714

I have done multiple development projects with clients and have worked with banks on financing them. I am just alittle confused on how exactly the loans are profitable. For example, most construction loans are interest only and the loan includes about like 2-3 years worth of interest reserve. So if a borrower builds a project and uses the interest reserve to pay the interest each money, they are just paying back the bank their initially money. Heck, when the project is stabilized, they just refinance the loan with a perm lender and there was still some interest reserve left. So I don't fully comprehend how construction financing can make money? This scenario has happened countless times.

Comments (16)

Jan 23, 2014

Ideally the construction lender should also provide the permanent financing. Oh and origination fees and stuff.

Jan 23, 2014

Fee's and it doesn't really "include" interest reserves. Reserves for interest are taken out of the loaned principal, a lender is practically guaranteeing he will recive all or part of the interest of the loan.

The questions is, with all the recourse and structure in construction loans how does one not make money...

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Jan 23, 2014

What SHB said. Think about a $10 million loan ($9 million project fund, $1 million reserve fund). I wire you $10 million, you give me the $1 million back in interest payments over the first few int payments and you still owe me $10 million in principal. Like SHB said, the reserve fund is basically a guarantee you will receive x amount of interest back.

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Jan 23, 2014

SBed both of you, that makes perfect sense

Jan 23, 2014

i'm really not satisfied with these explanations. why even give them that reserve money in the first place? just keep it yourself and only give them $9m.

Jan 23, 2014

The lender builds in the interest reserve because they realize there is no cash flow during the construction phase to cover interest payments. However, once construction is complete, the loan is refinanced with permanent debt, and that debt pays back the initial balance of $10mm (in this example).

Jan 23, 2014

For some reason my group doesn't do a lot of interest reserves. From our perspective, we don't make much money on construction loans--the hope is that you can win the permanent deals and/or maintain a good lending relationship with a quality borrower. Also, in many cases we just have excess money to lend and we're not going to turn down a small, short-term return in order to maintain no return.

Jan 23, 2014

On SHB's point about recourse though, I am increasingly see a trend where construction loans are limited or no recourse. Granted, the developers have a ton of experience, but still, the lending market is getting pretty competitive if this is the case.

Jan 23, 2014
TeddyTheBear:

On SHB's point about recourse though, I am increasingly see a trend where construction loans are limited or no recourse. Granted, the developers have a ton of experience, but still, the lending market is getting pretty competitive if this is the case.

I have definitely seen this happen on the lifeco side (and yes, I'm talking post-2008). Are you seeing any banks offer this yet?

Jan 23, 2014

Yes we advised a major developer and were able to secure non-recourse construction financing from one of the largest banks in the country. From what I understand banks are willing to go non-recourse on multifamily, since it is the safest asset class. I have now seen banks approach us on deals and they flat out said if they got good experience and a good project, that they could go non-recourse. Again still havent seen anything on other asset classes yet, but everyone is hungry for multifamily.

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Jan 24, 2014

You're still getting the interest, even if its paid out of reserve. Also, the upfront fees may seem small, but its not because, as you said, the construction loan will get refinanced in a few years and then that fee is not distributed over very long.... it's all gravy. Additionally sometimes you've got a prepayment fee if they pay you back to early and that's more money in the bank.

Jan 24, 2014

I can confirm Teddy's anecdote with (presumably) a separate multifamily project going into a Texas city that is also non-recourse. The lender on this particular project was a large regional bank, not one of the big boys and the developer is a reputable (primarily) regional builder.

Jan 24, 2014

Often times construction loans aren't all that profitable. They're high-risk, unfunded loans. Once the property is stabilized, the developer often flips the property or gets their perm debt from Fannie, Freddie, life co or CMBS.

Jan 27, 2014

Plus, the loan is a demand deposit until drawn

Jan 27, 2014

You may get fined for prepayment so the risk of early payoff goes away.

Best Response
Jan 28, 2014
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