@Michael Palmer As a general rule of thumb bank originated construction debt will be WSJ Prime +1 point with a floor, 1 point origination and 75-80% LTC while meeting certain LTV thresholds (normally 70-75%). Alt lenders will normally be higher on fees, rate and perhaps leverage at time of close but that's not always indicative of cash required to operate.
Before I jump into the cash required to operate which isn't given enough attention by most investors there are additional fee related questions a borrower should ask any prospective lender: Are the 3 points inclusive of loan doc prep? Are loan docs attorney prepared or prepared in house...big difference on costs there. Similarly, is an appraisal required? Some alt. lenders do not require an appraisal. Depending on these answers one lender who charges 3 points could theoretically have lower total transactional costs than a lender who charges only 2 points and its important to understand all fees associated with each lenders origination process.
Now onto cash required to operate which requires most attention when originating construction loans and is the point I really want to emphasize in this post. Most borrowers focus on rate, leverage and points and are most focused on how much cash is required to purchase the property and originate the loan. This is a huge mistake as there are other terms and lender administration processes that will have a far greater impact on how much cash is truly needed to execute on any given project and that's the cash amount borrowers should be aware of.
How are interest payments handled?
1.Is there an interest reserve and is it funded entirely by borrower at closing or is it capitalized into the loan? Interest reserves will greatly impact cash to close and cash to operate and capitalized interest rates will reduce required cash for duration of project. Here's an example comparing three different loan originations:
Loan A: No interest reserve, but $15K est. interest payments for duration of the loan. The lender will not require any of the anticipated interest payments on date of origination and borrower will have lower cash to close requirement, although $15K in interest payments will be required to service loan through duration of project.
Loan B: Lender requires $15K interest reserve funded by borrower at settlement. This loan will have the highest cash to close requirement out of these three examples although the interest payment is merely being fronted as opposed to being paid monthly.
Loan C: Capitalized interest reserve with an 80% LTC loan. The borrower will be responsible for $3K at closing while the lender will fund the remaining $12K for the interest reserve. Technically Loan C will require a higher cash to close than Loan A, but overall less cash will be required from borrower during life of loan.
Contingency:
No need to go through the same process to illustrate contingency but contingent funds can be applied to the loan interest example above. It's always important to have contingency reserves and having a healthy contingency line item that's capitalized can greatly reduce cash during life of loan.
Loan Administration:
Remember construction lenders release for completed work and the borrower has to navigate the process by which the work is completed in order to obtain reimbursement. Loan administration can have a huge impact on how much cash is required to advance projects. Here's a few examples:
Does the lender release for materials on site or do they have to be installed?
Does the lender hold back retainage? Some lenders charge 5% released upon C/O, others release once that particular line item is approved by local inspection agency. Some lenders do not withhold any retainage. It varies, but when retainage exists that will drive up the cash to continue to advance the project because borrower won't be receiving draw releases equal to their outlay.
Are soft costs like permit and architectural fees drawable and when are they released? Upon first draw or at C/O? Can have a huge impact on cash flow for borrower.
How frequently can loan draws be processed? Once a month may be difficult for some borrowers and lead to strain on advancing the project.
Are there minimum draw releases? If borrower has a $100K rehab budget but the lender has $50K draw minimums, borrower will require more cash to advance project than a loan that has lower or no minimum draw releases.
Then there's the human part of the administration process. A borrower is more inclined to face adversity with a construction project than most other types of real estate investing. How is this handled by the lender? Will they institute the default rate over a technicality such as missing the completion date by a few months or will they ignore the default rate because they see the reason for the delay wasn't entirely borrower's fault and borrower has a plan of action to get the project on track? Is there a funky property tax issue that arises with the collateral that is a local municipality error and can lender quickly analyze the situation, assess and articulate the risk and allow draws to carry on or will they make the life of the borrower miserable? These are just examples but can have an enormous impact on your borrowing experience.
The best way to feel out the type of lender you will be dealing with is by seeking referrals and communicating directly with them during the origination process. If there loan origination/underwriting process is robotic, expect a robotic loan administration process more times than not (which is generally a bad borrowing experience, particularly if there's adversity). If you receive a loan application that reads: How many flips have you completed in the last xyz years? How many new builds have you completed in the last xyz years? etc. etc. and your interest rate and loan leverage is tied to this "experience", expect robotic loan administration.
Hope this helps in selecting the best lender.
