Business Construction Loan
The commercial construction activity in the US is growing. Spending in this sector increased from $90.6 billion in 2017 to $92 billion in 2018.
At a macro level, the country’s economy is back on a steady growth path. The US’ real GDP grew at 2.3% in 2017, and the same is expected to be 2.7% in 2018. The Frank/Greenspan recession is over with. The unemployment rate is bound south. It was 4.1% in 2017 and is expected to come down to 3.8% in 2018.
These economic indicators create a positive sentiment among businesses to construct and own their workplaces rather than renting or leasing them. There are good reasons for supporting this tendency. Historically, the commercial construction activity has bounced back since 2012 due to strengthened top-lines and bottom-lines of businesses.
The general consumer spending has also increased, and this momentum is expected to retain. Along with these factors, the amount of vacant office spaces has come down, indicating a growing demand of commercial floor space. Most of all, the commercial construction index among the industry’s contractors stood at a high of 73 in the second fiscal quarter of 2018.
The above facts and figures bring the focus on the subject of commercial construction loans. In this article, we explore the what, why, and how of it, and provide a broad understanding of the subject and its process.
What is a business construction loan?
A business construction loan is commercial lending by a financial institution to a company or an individual, for the purpose of constructing their own workplace, office, service area, or other such premises.
Usually, such loans applications are submitted to regional and local banks who have sound knowledge and understanding of the business environment where the borrower wishes to construct their working premise.
On top of this, they are also aware of the prevailing market prices of land and building, labor cost, material cost, and various other cost incurring factors.
Hence, they are in a better position to assess the risk factors and determine the feasibility of the project. Of late, though, other financial institutions such as insurance companies, private lenders, and even national banks have entered the business of commercial construction loans.
Obtaining a commercial construction loan is a lengthy and somewhat difficult process. This is so because there is always a certain amount of uncertainty attached to a company’s performance. If a business fails to perform as projected in the loan application, its capacity to repay the loan is diluted. This factor increases the lender’s risk perception of any business construction loan.
Hence, lenders are extra cautious while assessing these loans, and have a more rigorous and vigilant approval process than other types of loans.
Business construction loans are available for various types of real estate. Prime among them are apartments, warehouses, medical and healthcare set-ups including hospitals and clinics, mixed-use, office, retail and self-storage spaces.
Why should one opt for a business construction loan?
It is extremely unlikely that a company willfully self-finance its business construction project. This is true even if that party possesses adequate resources to do so.
The obvious reason is risk aversion. Just like the lenders, the borrowers are also aware of their business risks, and hence they would like to ‘partner’ or ‘share’ this risk with the lenders by opting for the loan process. Besides, 100% self-financing also means blocking a significant amount of funds at a go, in a single activity.
This can stress their short-to-medium-term cash flow. In fact, such a move can suck finances from other priorities of the business, such as R&D, customer service, technological upgrade, diversification or expansion, digital transformation, and more.
A business construction loan, on the other hand, offers borrowers the following advantages:
- The convenience of loan repayment in installments, hence capital is not ‘unfairly’ blocked in one activity at the cost of the other.
- Loan disbursal in parts. Banks usually pay the contractors in pre-determined stages. Hence the contractor is more attentive to the timely progress of the project. This avoids delay in completion and cost escalation.
- Tax incentives. This will sound like music for both the large and small businesses. The Tax Cuts and Jobs Act (TCJA) of 2017 offer attractive tax incentives and cuts for a wide range of businesses, be they small or big. For the larger business houses, these benefits include corporate tax cuts (which is what is required if you want job growth), instant tax cuts under business expensing head, and enhanced real estate depreciation terms.
- The smaller businesses also stand to benefit due to this act. Partnerships, limited liability companies, and sole proprietors can now benefit from the TCJA provision that allows up to 20% deduction for commercial construction. As Cornwell Jackson, certified accountants, claim, “smaller businesses may jump on the building bandwagon, resulting in more revenue for construction firms.”
- For a detailed appraisal of tax benefits under TCJA, please talk to your tax consultant before finalizing a commercial construction loan application.
How to obtain a business construction loan
Due to higher risk factors in this type of lending, commercial construction loan applicants have to go through a more detailed and lengthy process of application. This process can be understood in three steps as below.
How to apply for a commercial construction loan
Loan application, evaluation, and approval
As a first step, the company wanting the loan fills up the prescribed application form and submits it to the lender. Once this application is submitted by the company, the bank’s internal staff examines the merit of the application in detail. Among the primary considerations, these are the important ones:
- The applying company’s financial soundness
- Its line of business and business plan as submitted along with the application
- Performance and profit viability of the proposed business premises in the local environment
- Easy availability of human resources and other material and non-material resources in and around the proposed site of construction
- Accessibility of market routes from the proposed business premise
If the bank executives are satisfied with the “business blueprint,” they will forward the proposal with their observations to the bank manager. She or he will go through the study, and if deemed fit, they will give a primary approval to the loan application.
The bank’s underwriter will then draw detailed terms of the loan agreement. This document contains the bank’s approved amount of loan, terms and conditions for approving the loan, and other formal text.
It is equivalent to the ‘first draft’ of the agreement from which the applicant can determine if their expectations are met. After a review, the borrower signs the terms’ document and returns it to the bank, thus conveying their readiness to abide by the bank’s conditions and procedure for approving the loan.
Once the bank receives this document, its underwriter prepares the full and final agreement, with details such as the loan tenure, interest, repayment roadmap, default penalties, legal bindings, and more. The borrowing company studies the terms, and upon its agreement, the process is closed by both the parties putting their signature to it. The loan thus comes into effect.
A commercial construction loan is more complex than a house construction loan
Any business aspiring to obtain a commercial construction loan must understand that it is different from a house construction loan. It carries a heavier risk burden, and the fund requirement is also higher than that needed to construct a house.
The company must be ready to undergo stricter scrutiny and has to provide more supporting proof and papers than those required for a house loan. Besides, it also has to provision for around 20% to 30% of the total project cost, since the lender usually sanctions 70% to 80% financing. This is the lender’s way of hedging its risk to a certain extent.
Among the supporting documents that a borrower needs to furnish along with the application, these are important:
- Company’s financial balance sheets
- Company’s tax returns
- Details of company’s immovable assets and their financial worth
- Company’s pro forma
- The business plan for the proposed commercial set-up
- Cost projection and tenure of construction – please note that the bank may also ask for a detailed structural plan and other engineering plans of the proposed building.
- Details of the construction contractor – the lender can, and does in many cases, contact the contractor directly for details and clarifications on various project-related matters.
Most of all, a reputed guarantor for the loan acts like the borrower’s spokesperson. Hence, it is always advisable to include a reputed guarantor in the loan application.
Three types of loan terms
There are three types of terms for commercial construction loans:
Short-term loan: This instrument typically meets the need of funds during the construction of the commercial premise, up to its completion stage. It has a flexible tenure which can end at any point in the construction process as mutually decided by the borrower and the lender.
Long-term loan: This is the type of financing wherein the borrower starts repaying after the commencement of its business at the newly constructed premise. The interest payment and repayment of borrowed capital can stretch as per the schedule laid out in the terms.
Mini-perm loan: This is a hybrid of the short and long-term loan formats. It is often created to help the borrower refinance their original loan.
This is how a proposal for a commercial construction loan is conceived, submitted, assessed, approved, and disbursed.
But wait, a business person is also a family person, and they need a good home as much as they need a good workplace. While on the subject of a commercial construction loan, let us also provide a snippet of the house construction loan process.
A bit about house construction loan
A home construction loan is relatively easier to obtain than a commercial construction loan since its risk perception is low. The process for obtaining a home construction loan has six main steps:
- Having a good credit score – This is of utmost importance, as most decisions for home loan approvals are based on this score.
- Finding a good agent – who is reputed, reliable, and who can do all the leg-work.
- Get pre-approved – Put your financial standing in order, get a good idea of your financial worth, and how much you can borrow.
- Search for a good builder – Scout the locality where you want to construct your home and finalize a good housing scheme. Sit jointly with the builder and your agent, and work out a good home plan. Next, get it signed by the builder.
- Apply for the construction loan: Choose the lender who offers the best rates and completes the paperwork. Important documents to submit along with the loan application include the offer, the contractor’s credentials, proposed home insurance plan, home plans, blueprint and specifications, construction tenure, and of course, a signed contract with the builder.
- If you have planned well and your expectations are realistic, your home construction loan should pass smoothly. Often, home buyers opt for the lender with whom the builder is associated for some time. Many hassles can be ironed out due to the good rapport shared by these two stakeholders, and the buyer can breathe easy while their loan application is processed.
In summary, the loan option for either commercial construction or home construction is emerging as a smart choice because of the multiple benefits it offers to the buyer.
Demand for commercial real estate in the US is surging. For businesses, this is the ideal time to switch to self-owned workplaces constructed with a bank loan.
The enhanced value appreciation of a commercial real estate in a thriving market can make up for the interest burden of the loan. In addition, with the loan option, one does not need to block capital from business to construct a workplace.
This allows for adequate fund allocation for other vital business activities. And there are intangible benefits too – self-owned offices are known to create happier workplaces where productivity, performance, innovation, and passion get a boost. Besides, it adds to the business’s stature, while the employees’ morale and their confidence in the company grows.
Above all, there is no place like your own. Just as you own your business, you can also own the location it is at, and have the best of both the worlds.
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