A construction loan is a short-term financing facility used to fund the ground-up development or major renovation of a commercial real estate property. Unlike permanent loans where the full balance is funded at closing, construction loans are disbursed incrementally through a draw schedule as the borrower meets defined construction milestones. The borrower pays interest only on the amount drawn, not the full commitment. Construction loans are typically floating-rate, priced at a spread over SOFR, and carry terms of 18 to 36 months depending on the project scope. Lenders underwrite construction loans based on the project’s projected stabilized value and income, the borrower’s development experience, and the general contractor’s qualifications.
How It Works in Practice
Construction lending involves a level of complexity that permanent lending does not. The draw schedule is the heartbeat of the loan — each draw request must be accompanied by an inspection report, lien waivers from subcontractors, and evidence that the project is on budget and on schedule. If the project falls behind or runs over budget, the borrower may need to inject additional equity before the lender releases the next draw. Interest rate risk is a significant concern because the construction period may last two or more years; many lenders require the borrower to purchase an interest rate cap to protect the project’s economics against rate increases. The transition from construction loan to permanent financing (known as the “take-out”) is a critical milestone that must be planned from day one. LoanBoss helps track draw schedules, budget-to-actual progress, and the construction-to-permanent transition timeline.
Related Terms
Part of the LoanBoss CRE Debt Glossary. For hedging-specific terms, see Pensford’s resources.