Commercial Construction Loan

[Van Ngo]

Hi everyone, we are in the process of building a 7 units complex downtown area, San Diego. We are about a month away from getting the permit (2 years now) and we own the land (value at 650K), any guidance on commercial loan would be great. Although we have great income, but nothing to the amount that gonna need for the project. Also anyone has experience with how does getting a builder play in the process of applying? I'm assuming we just need to identify a builder? or do we need a contract? 

[Erik Browning]

Quote from @Van Ngo:

Hi everyone, we are in the process of building a 7 units complex downtown area, San Diego. We are about a month away from getting the permit (2 years now) and we own the land (value at 650K), any guidance on commercial loan would be great. Although we have great income, but nothing to the amount that gonna need for the project. Also anyone has experience with how does getting a builder play in the process of applying? I'm assuming we just need to identify a builder? or do we need a contract? 

Hi Van, so your income will not be a factor in getting a commercial loan with 7 units. For this property type, it will be based on what is called the DSCR Ratio. DSCR = Debt Service Coverage Ratio.

Let's do a very simple, reduced example to illustrate how it works:

Let's say the cost of the entire debt service (loan) = $1000/mo

Let's also assume your rental income from all of the units also = $1000/mo

You divide the rental income / debt service (aka DSCR): $1000/$1000 = 1.00

Most lenders like to see a DSCR ratio of 1.20 or better, meaning for every $1000/mo in your debt service, you are getting $1200/mo in rental income.

Again, the example is simplified to illustrate how it works.

There are lenders that do loans with a DSCR ratio of < 1.00, or even no DSCR, but there is always a trade off for those types of products - typically a higher interest rate.

Also, keep in mind that this example is for an already-built property, not a new construction.

For a new construction, you will need to get a loan from the lender that is specifically for construction of a property, called a construction loan. Private money lenders as well as some institutional lenders will help finance this for you. Then once construction is complete, you will get it appraised and obtain the Commercial Loan using the DSCR ratio, and other factors, to put you into more palatable financing terms.

Construction loans are usually around 30% down (I'm sure you can find other options that are less) and they require interest payments throughout the construction process. The builder will receive draws to help them with paying for materials, permits, and labor.

Try to not associate the conventional methods of buying a single family home to the either a construction loan or commercial loan. These are different. Additionally, commercial and construction loan interest rates are higher and can require a balloon payment - meaning you will have to refinance out of them every so often.

Why are they higher and why does that matter?

The reason they are higher is because of a few things: 

1. You are collecting income from the property on a monthly basis

2. You are able to depreciate the building and offset your income, making it seem like you are actually making less money than you actually are. Your income taxes are substantially lower if the deal is good. 

These 2 things are a good trade off for a higher interest rate, in my opinion. I'd rather pay less in taxes and receive the same amount of income and still pay less in taxes.