How Methods of Construction Affect Construction Lending

There are three basic approaches to home construction, site built, modular and manufactured.  Site built homes, also known as “stick built” in the industry, are constructed entirely on the building site.  Site built homes could be a panelized home, or a kit home, such as a cedar home or a log home.  In the case of panelized, the panels are constructed in a factory and delivered.  In the case of kit or log homes, the special construction materials are precut and delivered.  For log homes, historically construction loans are very difficult to obtain because log home comparable sales will be required on the appraisal, and in a slow market it would be unlikely that these would be close enough, similar enough and recent enough.

Modular homes are built in sections at the vendor’s factory, usually to pre-exisiting plans.  Custom modular homes are possible when the buyer pays additional engineering fees.  Modular homes sections are transported to the site on trucks, and usually removed by a crane that swings it right into place on top of a recently built foundation, or onto other previously installed sections of the structure.  A typical section might be a couple of rooms.  Upgrades and finishes are often installed on site by the contractor who built the foundation and is responsible for the entire job.  Like stick built homes, modular homes conform to all local and state building codes, and once completed, should be indistinguishable from a stick built home.  Appraisers are not expected to use only modular home comps.  Total construction costs are generally significantly lower and construction time shorter for modular homes. 

From a construction lending standpoint, the major implication of modular home construction is the timing of the payments to the modular home vendor.  Modular home dealers typically want a deposit, some money during the manufacturing period, and the rest on delivery.  Construction lenders disburse money in draws subsequent to the work being done.  They want to lend more money when the real estate (real property) is further improved.  Modular sections in the factory or on the truck are personal property.  They become real property when attached to the land through a permanent foundation.  Borrowers using modular construction should have extra liquid reserves to bridge the financing gap.  If they can pay deposits and progress payments out of pocket and be reimbursed at the point when the sections are secured to the foundation, the situation is usually workable.  Negotiations involving the modular home dealer and the construction lender should begin ealy in the process on this issue.  The same timing of payments issue can present itself on stick built kit or log homes as well.

Manufactured homes are also built in a factory.  They travel on wheels attached temporarily to a non-removable steel chassis which is a structural part of the home.  Manufactured homes are only built to federal HUD standards, do not meet local and state building codes, and are restricted by zoning as to where they can be placed.    “Single wide” mobile homes are usually on leased land in mobile home parks and on non-permanent foundations.  They have their own personal property financing structure.   It is possible to obtain a construction loan to put a new “double wide” or “triple wide” on a permanent foundation.  Terms of these construction loans tend to be higher than for other types of construction.

Can will build a log home or other kit home?

The short answer is yes, you can get a construction loan to build a log home.  We’ve done them.  The problem is that the property has to be appraised, and it must be demonstrated that log home construction is common for the area.  Unfortunately, the way that is demonstrated is with typically with at least two of the recent comparable sales on the appraisal being log homes.  In areas where a log home might be built, sales are usually very slow these days, and this seems very unlikely.  Kit homes like a cedar home or an A-frame might be similar enough to typical construction in the area that no special “like comps” would be needed.  Try building an octagonal structure or one of the type of kit homes that has pod type connected rooms and you could likely anticipate insurmountable underwriting obstacles to obtaining a construction loan.

How do we qualify for a construction loan?

There are two main elements of qualifying for a construction loan, the property and the borrowers themselves.  In regard to the property, it should be an owner occupied single family residence (some programs allow owner occupied duplexes), or a second home.  It should be clear from the circumstances that the borrowers intend to occupy the property.  Generally there should be no indication that the borrowers might sell the property after construction is completed.  Banks do not want to give cheap construction money to someone doing a spec house.  Single close construction lenders want their construction loan program to be putting servicing in place over the long term.  If the property to be built appraises for less than the borrowers’ current residence, this might look like a “spec deal” and would be an area of concern.  If the property is not where the borrowers live and work now, and is not in what for them would be an obvious second home area, this might also get the construction lending underwriter thinking “spec deal”.

The property should be for a complete house that is neither an under, or over-improvement for the area.  You cannot get a construction loan to take you through the framing stage, thinking that you can do the finish work yourself over a period of time.  You cannot get a construction loan to build the guest house first, thinking you’ll move into it and build the main house later, the same way you could not get a conventional loan to buy, for example, a 3 car garage structure with 800 square feet of guest space above it.  This type of property is an under-improvement and cannot be appraised, and could only be sold to a cash buyer.  If you are the first in your market area to add or build square footage in excess of what is common, you may well find there are no comparable sales for the appraisal.  Existing structures on the property should not be commercial, such as a shop.   The property should be residential in nature and not agricultural.  There are title insurance issues if work has started, but construction loans to finish the work are still possible.

If you are a licensed general contractor who makes your living from job income (not capital gains generated from the sale of spec homes), it appears from the property value and location that the finished house will be owner occupied, and you can document sufficient tax return income working for your own company, owner builder is possible.  Having a GC license but working for someone else is generally not acceptable in this tough construction lending environment.  You’d have to be an “approvable” builder with past “happy homeowners”, vendor references, and a track record with your own company.  Generally, a fixed price contract with a builder is required.  Cost plus contracts and construction supervisor arrangements are rarely allowed in this market.  Construction lending is also back to where it was a decade ago in that the more restrictive of loan-to-cost or loan-to-value calculations is used.  You must have a certain amount of cash in the deal, or equity in the lot.  None of the single close construction lenders still in the business are lending off the appraised value without regard to cost. 

As borrowers, you must be able to fully document adequate income to qualify for the single close construction loan as well as your other obligations.  Your middle credit scores need to be at least 680, and 700 in some circumstances.  More than two years of self employment in the same business in the same market area is required in that at least two years must be reflected on tax returns.  You are not going to be able to blend in the income and liabilities of non-occupant co-borrowers in order to meet debt ratio requirements.  You must have verified reserves (about one half of which should be in non-retirement, liquid accounts) after close of escrow on the construction loan.  Reserve requirement minimums generally vary from 6 to even 12 or more months of the projected PITI (principle, interest, taxes and insurance) based on the locked permanent financing rate.  There can be limits on the number of financed properties, and if a minimum of 30% equity cannot be proven on current rentals or the rental of current principle residence, you may find that actual or market rents will not be used to offset those payments.

What is the difference between a lot loan and a land loan?

There is no universally agreed upon distinction in the industry.  Our lot loan is generally a maximum of 10 acres.  We can go to 20 acres if the property is in a subdivision of similarly sized parcels, as demonstrated by recent comparable sales of vacant parcels.  On all lot loans, no structures are allowed on the property, whether of value or not.  In general, lot loan programs have size limitations, as well as distinctions between finished lots (public water and sewer at the lot line), and unfinished lots which will rely on septic and/or private well, both of which are usually installed when construction begins.  Lots must be buildable, and zone residential.

“Land loans” is a more general category.  Our vacant land loan is for rural/agricultural acreage with limitations.  That particular program won’t allow a residence on the property, but would allow outbuildings like sheds or barns if not given value.  These properties would be zoned agricultural or agricultural/residential, and also must be buildable (see the program description for other limitations).  Vacant land zoned commercial, industrial, multi-family or property that can be subdivided is very difficult to finance these days.  One reason may well be the fact that to obtain a commercial construction loan or a land development loan is this difficult mortgage market, the land would probably have to be free and clear for the deal to “pencil out”.  Commercial banks then have no motivation to do a vacant land loan, and they don’t want to take back non-income producing property.

What is a single close construction loan?

A single close construction loan, also known as a one time close construction loan, provides construction funding and is also the permanent financing.  This is in contrast to a more traditional interim construction loan which would require “take out” permanent financing to pay it off.  Single close construction loans have two basic structures.  Our construction loan programs 1, 2 and 3 are 30 year loans in which the first 12 months are the construction period, during which time the loan is interest only on the amount disbursed.  These loans begin to amortize after 12 months when the house is completed, and are 29 year amortization from that point, since 1 year of the 30 year loan was done as interest only.  For example,  a 5/1 ARM is fixed 5 years.  The first year is interest only, and the next 4 more years are the beginning of the 29 year amortization period.  This is the first type of single close construction loan where there is no note modification after construction is completed, and the construction rate is the same as the initial fixed period rate.

Our program #4 is an example of the note modification type single close construction loan.  In this program, the borrower is locked in on a 5/1 ARM which begins after the construction phase.  The construction phase of 12 to a maximum of 18 months is at a monthly adjustable rate.  Historically, these note modification type construction loans had a prime based initial construction phase with the rate being some margin above or below prime.  In our case, the construction phase is 4.5% above the 1 month LIBOR.  Like all bank construction loans, it is interest only on the amount disbursed during the construction period.  After the construction is done, the 5/1 ARM program begins.  Here you would have 5 years fixed at your locked note rate, and 30 year amortization.  A note modification is done when construction is complete.  This simply involves a notarized signature on a few documents to be recorded.  If someone had sold their current home, they could pay down the principle prior to modification, so the 30 year loan would have a lower payment.  Being a single close construction loan, just as with our programs 1, 2 and 3, the loan file is not redocumented, and the property is not re-appraised.

Types of construction loan builder contracts

Construction loan programs 1, 2 and 3 require a fixed price contract with the builder, and a cost breakdown to match.  The concept of fixed price seems self-explanatory.  Any builder profit is built into the bottom line.  A “cost plus contract” involves the builder saying essentially, I will build the house for whatever the subs end up charging plus my fee.  In this case the builder specifies their fee, and provides a cost breakdown derived from an estimate of what the subs would charge.  Construction loan program # 4 allows a cost plus contract but requires a 10% hard cost contingency in that case.  A builder is still required.  You cannot act as your own general contractor unless you are a general contractor, and it is clear you’re building your own house, not a spec house.  If you are a GC, you must make your living from job income (not capital gains or another job), and you must have your own company.  If all of these criteria are met, you can act as your own general contractor.

Starting construction with our own money won’t be a problem.

This is not a good idea.  Historically, most construction lenders won’t touch a deal that has pre-started.  Possible mechanics liens create title insurance problems.  Best case, and at a minimum, the title company and lender would want construction to stop for the mechanics lien window of 60 days, after filing certain notices.  The title company would probably want to underwrite the borrower’s income and assets before issuing title insurance, and they’ll want indemnification agreements signed to cover themselves if there is loss of lien priority.  Even if a title company can be found to issue title insurance at the time the construction loan is funded, most banks won’t do this scenario. 

More so than in new construction, pre-starts happen in a rehab/addition situations, where the project cost are more than expected, and the borrowers begin seeking a construction loan when their funds are exhausted.  They then may not have the liquid reserve requirements after close of escrow to meet program guidelines.  We can now do these pre-starts on Construction Loan Program #4 if all funds are documented, requirements for liquid reserves after close of escrow can still be met, work has stopped long enough so mechanics liens are not a problem, and title insurance can be obtained.  Still, not a good idea to pre-start.

Construction lenders will lend off of what the house will be worth when completed.

Between 2003 and 2008 this was true for many construction lenders.  Construction lending had moved to where, if a bank was going to be competitive, they needed to ignore how much cash the borrower had in the deal, and just lend of the end value.  Multiple construction lenders were doing 100% of costs as long as the appraised value as completed gave them the loan-to-value ratio for which they were looking.  This was even done on stated income loans.  Since mid-2008, we’re back to where we were a decade ago such that construction  lending is now done based on the lesser of two numbers.  One number is total costs (lot price or value, plus prepaid soft costs, plus construction hard costs) and the other an appraised value as to what the house would be worth in today’s market if completed already as planned.

My land has to be paid off to get a construction loan.

Your vacant lot does not have to be free and clear.  The current value of the lot is added to construction costs and prepaid soft costs.  Total costs are then compared to what the house would be worth if completed already as planned, as demonstrated by an appraisal.  Construction lending is back to the more conservative approach of 10 plus years ago wherein construction lenders lend off of the lesser of these two numbers, total costs or appraised value.  If loan-to-value and loan-to-cost numbers are in line with current bank requirements, the new construction loan can pay off the lot loan on the property.  In this way, equity in the lot comes into consideration, but the lot does not have to be free and clear.