What it means
Building a property takes time, and the money for construction is normally provided by a short-term loan. That loan is not meant to stay in place; it is meant to be repaid once the building is finished and let or sold.
The take-out commitment names the permanent lender who will provide that repayment, and sets the terms on which it will do so. The construction lender relies heavily on the commitment.
Without it, the developer might complete the building and then be unable to find long-term finance, leaving the construction loan unpaid. With it, the construction lender can lend with much more comfort and often at a lower price.
The commitment usually comes with conditions. Typical ones are that the building must be completed by a given date, a minimum share of the space must be let at certain rents, and the property must reach a stated level of income relative to its debt.
If those conditions are not met, the permanent lender may refuse to fund, which is why developers watch them closely. Permanent lenders commonly size the loan by two tests: the loan must not be more than a set percentage of value, and the income must cover the repayments by a safe margin.
The smaller of the two results is the amount they will lend. That is why a strong building can still receive less finance than the developer hoped for.
A related nuance is cost. Lenders charge a fee for making the commitment, often a percentage of the loan, and the fee is paid whether or not the loan is ever drawn.
The developer should treat this as the price of certainty.
In practice
Real-world examples.
Example
A developer building apartments obtains a take-out commitment from an insurance company for a 25-year loan. The construction bank agrees to lend $18,000,000 because the commitment covers its repayment. When the building is finished and 90% let, the insurer funds and the bank is repaid.
Example
A shopping centre owner is refurbishing a unit and wants a short loan. The construction lender will only proceed with a written commitment from a long-term lender. The owner pays a commitment fee of 1% so that the bank has certainty.
Example
A hotel group builds a new site using a short-term loan. The take-out commitment requires an occupancy rate of 65% for three months before it funds. The first months are slow, so the group has to extend the construction loan at a higher cost to reach the test.
Formula
Calculation
Maximum permanent loan = the lower of (value x maximum loan-to-value ratio) and (net operating income / minimum debt service coverage ratio / loan constant)
A developer is building an office block expected to be worth $4,000,000 with annual net operating income of $300,000. The permanent lender allows a maximum 70% loan-to-value, a minimum debt service coverage of 1.25 and uses a loan constant of 8% (annual payments as a share of the loan). The value test gives 4,000,000 x 0.70 = $2,800,000. The income test gives 300,000 / 1.25 = $240,000 of affordable payments a year, and 240,000 / 0.08 = $3,000,000. The lower figure, $2,800,000, is the amount available to repay a $2,500,000 construction loan with $300,000 to spare.Case study
Seen in the real world.
Eastbrook Developments is an illustrative, fictional company that built a $6,000,000 commercial building using a $4,500,000 construction loan. Its lender required a take-out commitment from a long-term lender before advancing funds.
The commitment promised a permanent loan of up to $4,800,000 provided the building was at least 85% let by a set date. Construction finished on time, but only 70% of the space was let when the date arrived.
The illustrative result was a cash squeeze. The permanent lender reduced its loan to $3,900,000, which left a shortfall of $600,000 against the construction loan, and Eastbrook had to find that sum from shareholders. The lesson was that the conditions in the commitment matter as much as the headline amount.
Watch out
Common mistakes.
- Treating the commitment as a guaranteed loan, when it depends on conditions such as completion dates and letting levels.
- Ignoring the commitment fee, which is paid even if the permanent loan is never drawn.
- Assuming the permanent loan will be as large as the headline figure, when the lender sizes it by value and income tests at the time.
Questions
People also ask.
What is a take-out loan?
It is the long-term financing that replaces a short-term loan, such as a construction loan, when it falls due.
Who is the commitment issued to?
It is usually issued to the developer, and the construction lender takes comfort from it, often by receiving an assignment of the developer's rights under it.
What happens if the conditions are not met?
The permanent lender can reduce the loan or decline to fund, leaving the developer to arrange other financing or extend the construction loan.
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