Construction loans: how budgets, draws, and guarantees work

A construction loan is not a lump sum. It is a commitment that the lender funds in stages as the work gets done, measured against a budget the lender has approved. Sponsors who understand that process close faster, draw on time, and avoid the cash calls that come from a budget that was never realistic.

How a construction loan is sized

Lenders look at two measures and lend against the lower result.

• Loan to cost. The loan as a share of the total project budget, including land, hard costs, soft costs, interest, and fees.
• Loan to value. The loan as a share of the appraised value once the project is complete and, for income property, stabilized.

The gap between the loan and total cost is the sponsor's equity. Most lenders require that equity to go in first. The loan usually does not fund until the sponsor's money is spent and documented.

The budget is the loan

The approved budget becomes the rulebook for every dollar that follows. It is broken into line items, and each draw is measured against them.

What a lender expects to see

• Hard costs supported by a signed contract with the general contractor, often a guaranteed maximum price
• Soft costs such as architecture, engineering, permits, legal, and insurance
• A hard cost contingency
• An interest reserve sized to carry the loan through construction and lease up
• Developer fees and any payments to related parties, disclosed plainly

A budget that is thin on contingency or interest reserve is the most common reason a project needs more equity midway through. Lenders and their consultants will test both.

How draws work

Construction funds move through a monthly draw process. The steps are similar at banks and debt funds.

1. The contractor submits a pay application showing work completed against each line item.
2. The lender's inspector visits the site and confirms the progress.
3. The lender collects lien waivers from the contractor and major subcontractors for the prior draw.
4. The title company confirms no new liens have been recorded.
5. The lender funds the draw, less retainage.

Retainage is a portion of each payment held back until the work is substantially complete. It protects the owner and the lender if the contractor does not finish. Build its release into your cash flow plan, because subcontractors will be waiting on it.

A draw that is missing a waiver or does not match the budget will be held. Delays compound quickly when contractors are not paid on time.

Guarantees and completion risk

Construction lenders carry a risk that a lender on a stabilized property does not. The building might not get finished. Most construction loans carry some form of recourse during the build, even when the permanent loan will not. Common guarantees include:

• Completion guarantee. The guarantor commits to finish the project and pay cost overruns.
• Carry guarantee. The guarantor covers interest, taxes, and insurance until the project stabilizes.
• Repayment guarantee. A full or partial guarantee of the loan balance, sometimes reduced as milestones are met.

Read these closely. A completion guarantee can become a larger exposure than the loan balance if costs run over. Lenders will weigh the guarantor's liquidity and net worth against these obligations.

Plan the takeout before you break ground

A construction loan is short term. It is meant to be repaid by a permanent loan or a sale once the project is complete and leased. Before closing, a sponsor should know which lenders would refinance the finished asset, roughly how large that loan could be, and what occupancy they will require. If the takeout loan comes in smaller than the construction balance, the difference has to be funded with equity at the worst possible time.

Extension options matter here. Most construction loans include one or two extensions, each subject to conditions such as a fee, no defaults, and a minimum debt service coverage ratio. Know those tests well before you need them.

A construction loan rewards preparation. A credible budget, a realistic schedule, adequate reserves, and a clear exit make the lender's decision easier and the draw process smoother. You can test how a finished project might size for its permanent loan with our debt sizing tool. When you are ready to discuss a construction financing, contact us before you commit to a lender.