What it means
Property developers rarely have the cash to pay for a project from their own funds, so they borrow in stages. A construction loan pays for the building work and is expensive and short, because the lender is exposed to the risk that the project will not be finished or let.
Once the building is finished and occupied, a permanent loan pays off the construction lender. Lenders make permanent loans on the strength of the income the property earns.
They look at the net operating income, the loan relative to the property value and the ratio of income to debt payments. Because the project is complete and operating, the risk is lower and the rate is usually lower too.
A takeout commitment often makes the whole structure possible. This is an agreement made before construction begins in which a permanent lender promises to provide the long-term loan once certain conditions, such as occupancy levels, are met.
The construction lender then knows how it will be repaid. Terms vary, but permanent loans commonly run from 10 to 30 years and may have amortisation (gradual repayment of principal) over a longer period than the term.
Some end with a balloon payment, a large final sum that the borrower must refinance or repay. Prepayment penalties are common, so early repayment can be costly.
The nuance is that a permanent loan is not always stable. If the project underperforms and the conditions for the takeout are not met, the developer can be left with an expensive construction loan that is due and no long-term replacement, which is one of the main risks in property development.
In practice
Real-world examples.
Example
A developer completes a 60-unit apartment block financed by a construction loan. After the units are 90% let, she takes out a permanent loan that repays the construction lender and runs for 25 years. Her interest cost falls because the risk of the project is now lower.
Example
A shopping centre owner refinances a short-term bridge loan with a permanent loan at a lower rate. The monthly payments fall, which improves the property's cash flow. The owner uses the extra cash to fund tenant improvements.
Example
A restaurant group builds a new headquarters funded by construction finance. A permanent lender agreed in advance to provide a 20-year mortgage once the building is complete and occupied. The group's accountant records the long-term loan as a non-current liability.
Formula
Calculation
Loan to value = loan amount / property value
Debt service coverage ratio = net operating income / annual debt service
Suppose a completed apartment building is valued at $5,000,000 and earns net operating income of $400,000 a year. A permanent loan of $3,500,000 gives a loan to value of 3,500,000 / 5,000,000 = 70%. If the annual loan payments are $300,000, the debt service coverage ratio is 400,000 / 300,000 = about 1.33. Many lenders look for a ratio of at least 1.2 to 1.25, so this loan would typically qualify.Case study
Seen in the real world.
Sandstone Properties is an illustrative, fictional developer building a $12,000,000 office block. It borrowed $8,000,000 in construction finance at a high floating rate and had a takeout commitment for a permanent loan of $8,400,000 subject to 85% occupancy.
By completion the building was only 70% let, so the takeout lender refused to advance the funds. The developer had to extend the construction loan for six months at a higher rate, costing an extra $250,000 in interest and fees.
Once the occupancy passed 85%, the permanent loan was funded and the construction loan was repaid. The illustrative lesson is that a permanent loan depends on the project performing, and the developer must plan for delays in letting. Sandstone now negotiates a longer construction loan term before it starts building.
Watch out
Common mistakes.
- Assuming the permanent loan is guaranteed once construction begins, when it usually depends on conditions such as occupancy and income.
- Ignoring prepayment penalties and balloon payments, which can make refinancing expensive later.
- Treating the word permanent as meaning the loan never has to be repaid, when it has a fixed term and a repayment schedule.
Questions
People also ask.
What is the difference between a construction loan and a permanent loan?
A construction loan is short term and pays for the building, while a permanent loan is long term and replaces it once the property is complete.
What is a takeout loan?
It is another name for the permanent loan, because it takes out the construction lender, and a takeout commitment is the lender's advance promise to provide it. Developers often need the commitment before the construction lender will agree to lend.
How do lenders decide how much to lend?
They test the loan against the property's value and its income, so that the loan to value ratio and the debt service coverage ratio both meet their limits. A stronger property can support a larger loan.
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