What it means
The staged drawdown is the defining feature. The lender releases money against a schedule of works, and each release is normally signed off by a quantity surveyor or monitoring surveyor who has inspected the site.
That structure protects the lender in an obvious way. If the project stalls at the foundations, the lender has advanced only the money spent so far, rather than a full facility sitting in a borrower's account with a half-built site as security.
Construction loans are priced higher than ordinary mortgages because a partly built structure is poor collateral. Rates are typically floating, terms usually run twelve to twenty-four months, and lenders size the facility against loan to cost or loan to gross development value rather than against a finished valuation.
Interest is frequently rolled up rather than paid monthly, because the project generates no income while it is being built. Lenders often set aside an interest reserve inside the facility, which means part of the loan exists purely to pay the loan's own interest.
The risk that ends most troubled projects is not interest rates but timing. Costs are fixed by the build contract, but delay pushes the take-out refinancing further away, and every extra month adds interest to a facility that has to be repaid from a sale or a long-term mortgage.
In practice
Real-world examples.
Example
A restaurant group borrows $1,200,000 to fit out three new sites, drawn site by site as each lease completes. Because the third lease is delayed by four months, the third tranche is never drawn in the first year and the interest bill comes in well under budget.
Example
A self-build homeowner takes a staged loan released against surveyor inspections at foundation, wall plate, roof and completion. A dispute with the groundworks contractor holds up the first sign-off, and the borrower has to fund three weeks of work from savings.
Example
A property developer's $5,000,000 facility runs out with the building 90% complete after a supplier failure. The lender agrees a six month extension for a 1% arrangement fee of $50,000 plus 1.5% on the margin, worth $5,000,000 x 1.5% x 6 / 12 = $37,500, so the delay costs $87,500 in finance charges alone.
Formula
Calculation
Interest for a period = outstanding drawn balance x annual rate x (period length / 12)
Loan to cost = loan amount / total project cost
A developer builds a small industrial unit with a total project cost of $4,000,000, funded by $1,000,000 of equity and a $3,000,000 construction loan, a loan to cost of $3,000,000 / $4,000,000 = 75%. The rate is 9% a year, which is 2.25% a quarter, and the facility runs for twelve months.
Draws are $600,000 in the first quarter, $900,000 in the second, $900,000 in the third and $600,000 in the fourth. The outstanding balance is therefore $600,000 during quarter one, $1,500,000 in quarter two, $2,400,000 in quarter three and $3,000,000 in quarter four.
Quarterly interest is $600,000 x 2.25% = $13,500, then $1,500,000 x 2.25% = $33,750, then $2,400,000 x 2.25% = $54,000, then $3,000,000 x 2.25% = $67,500. Total interest for the year is $13,500 + $33,750 + $54,000 + $67,500 = $168,750.
Had the full $3,000,000 been drawn on day one, interest would have been $3,000,000 x 9% = $270,000, so the staged structure saves $270,000 - $168,750 = $101,250. The average balance outstanding across the year was $1,875,000, and $1,875,000 x 9% confirms the $168,750 figure.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Tarn Bridge Developments, an invented light industrial developer, budgeted a $4,000,000 unit with $1,000,000 of its own equity and a $3,000,000 construction facility at 9%, expecting a twelve month build and a refinance onto a 6% investment mortgage on completion.
The build ran four months late after a steel delivery slipped. Because the loan was fully drawn by then, the extra interest was $3,000,000 x 9% x 4 / 12 = $90,000, and the lender charged a $30,000 extension fee, so $120,000 of unbudgeted cost landed on a scheme whose projected profit had been $600,000. That is a fifth of the profit lost to four months of delay.
The fictional developer's conclusion was that its interest reserve had been sized for the build programme rather than for the build programme plus a realistic overrun. On its next scheme it added a three month contingency to the facility term from the outset, accepting a slightly higher commitment fee in exchange for not having to renegotiate under pressure.
Watch out
Common mistakes.
- Budgeting interest as if the whole facility were drawn on day one, which overstates cost, or as if it were drawn evenly, which usually understates it.
- Sizing the loan term to the optimistic build programme with no allowance for delay, so an extension has to be negotiated from a weak position.
- Assuming the take-out refinancing is guaranteed, when the long-term lender will value the finished building on its own terms and market conditions may have moved.
Questions
People also ask.
Why is a construction loan more expensive than a normal mortgage?
Because a partly built structure is weak security, the borrower's exit depends on completion, and the lender carries construction and cost overrun risk throughout.
What is an interest reserve?
It is a portion of the facility set aside to pay the loan's own interest during the build, since the project produces no income until it is finished or let.
What happens if the project costs more than budgeted?
The borrower is normally required to inject the extra equity first, because most facilities are sized on loan to cost and lenders insist on cost overruns being funded before further draws.
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