Construction Loan Rates

January 27, 2011 by · Leave a Comment 

In general, your construction loan rate will either be the first year of an intermediate ARM like a 2/1, 5/1 or 7/1 ARM, or it will be an adjustable rate unrelated to the permanent financing rate.  It you get a 2/1 ARM, for example, the initial rate is fixed 2 years, and then would adjust annually the next 28 years.  The construction period would be 12 months, during which time the loan is interest only on the amount that has been disbursed (not the entire loan amount).  In the case of a 2/1 ARM (adjustable rate mortgage), after 12 months the house would be done (assuming all goes as planned) and the loan will be fixed one more year at the inital rate, and the loan will begin 29 year amortization from that point.  This would be the situation if you got a single close construction loan.

If your loan is only an interim construction loan (not the permanent financing), or if the rate during construction is adjustable, based on some index and margin over that index, with a promise of a note modification (without additional documentation) when the house is done, your construction loan rate will not be the same as your permanent loan rate.

Contingency Reserve

June 9, 2010 by · Leave a Comment 

A contingency is an addition to the cost breakdown, usually based on a percentage of the hard costs, to be used to fund changes during the build.  For example, the borrower decides half way through the build that rather than granite tile, they want granite slab in the kitchen.  They can either pay that out of pocket, or if they have a contingency reserve, that will fund the difference.  The money for changes cannot be shifted from one line item to another.  Historically, some banks have required a contingency reserve.  Currently, a contingency reserve is allowed, but generally not required on all of our construction loan programs.  Even when a contingency is desired, sometimes there is not room in the deal based on loan-to-cost calculations or the loan amounts for which the borrower can qualify.  Program # 4 allows for a cost plus contract (as opposed to fixed price), and in this case does require a contingency.  A contingency reserve may also be required if the borrower will be their own general contractor.  This is possible if one of the borrowers is a GC, they make their living from job income (not capital gains on real estate), and it is clear from the circumstances that they are building their own house and not trying to get cheap spec money.  Contingencies are usually 5 or 10% of the hard construction costs if used.

Interest Reserve Accounts

June 7, 2010 by · Leave a Comment 

An interest reserve account is another line item in the cost breakdown that is used to pay interest during the construction period.  A construction loan with an interest reserve account essentially uses borrowed funds to pay interest on itself.  Interest is estimated based on the expected rate during construction, the expected construction period, the loan balance at the beginning, and the final construction loan amount.  It is usually assumed that more money will be disbursed in the early parts of the build rather than linearly throughout construction.  With these parameters, total expected interest can be estimated, and an interest reserve amount can be added to the cost breakdown.

An interest reserve account would make no sense if a borrower is already maxed out on their loan amount either due to income qualifying, loan to cost or loan-to-value calculations.  For example, let’s say the construction loan is $400,000, total costs are $500,000, and the property is appraising for $500,000 (if completed already as planned).  Assume for illustration purposes maximum loan-to-cost of 80%, lot value of $200,000, construction costs of $300,000 and lot loan balance of $100,000.  The borrower here could get a $400,000 loan because they have 20% equity ($100,000) in the lot.  To close escrow, they would have to bring in closing costs since there is no room to roll them into the loan, but everything else would be covered.  Now let’s say interest is estimated to be $11,250 based on an average loan balance of $300,000 during 9 months of construction at 5.0%.  Total costs would now be $511,500 because $11,500 would be added as another line item to the $300,000 cost breakdown.  Since construction loans are based on 80% of the lesser of total costs or appraised value, the maximum loan amount is still $400,000, and the borrower would now have to bring in closing costs plus $11,500 to close escrow, essentially prepaying interest up front rather than getting a bill monthly.  This would make no sense. 

When there is room in the deal to allow for an interest reserve account, interest is charged and disbursed monthly based on average daily balances during the previous month.  You then pay interest on the interest, but if your interest reserve account is $20,000 for example, you are not paying interest on any part of that $20,000 until it is used.  This works the same way as other line items.  If cabinets were $20,000, you wouldn’t be paying interest on that $20,000 until cabinets were installed and that money was part of a draw.  The only difference between these $20,000 line items is that the $20,000 for cabinets would probably be disbursed all at once, whereas a portion of the $20,000 for interest reserve gets disbursed each month.  Partial interest reserve accounts are OK.  You would just begin getting a monthly bill when the money ran out.  Interest reserves are optional.

How Construction Loan Draws Work

May 26, 2010 by · Leave a Comment 

All bank construction loans disburse money subsequent to the work being done, and interest is charged just on the amount disbursed.  Some private money construction loans charge interest on the entire loan amount from the date of funding, but banks can’t do that.  In the past, there were some construction lenders who would impose a draw system on the borrowers and the builder.  They would say, for example, we have a seven draw system, and here it is.  Each stage like grading and foundation, or framing, had a percentage associated with it.  This method was too rigid, and is generally not used today.

The amount of each draw is based on the specific cost breakdown for that particular build.  The builder completes a portion of the build and requests a draw.  The bank sends out an inspector (usually not a bank employee but someone from their third party fund control vendor).  The inspector confirms that certain line items are done, although they are not typically inspecting the quality of the work.  Draws are then made based on the amounts on the cost breakdown associated with the items that had been completed. 

Start up draws for soft costs are allowed either as a percentage (usually not more than 5% of the total contract amount) or for specific soft cost amounts in the cost breakdown  “Soft costs” can include permits, school fees, and unpaid architectural fees, for example.  Retainage, a method affecting draws wherein 10% of the draw amount is retained until certificate of occupancy, no longer seem to be a part of construction lending.  If the deal is structured such that the lot is free and clear, and the borrower is still bringing more money into the deal, that money would be put into an FDIC insured account at close of escrow, and that would be the first money disbursed as work is done.

Draws can be made to the builder directly, or in some cases, to a joint account the borrower and builder have set up for the build.  Draws are generally not made just to the borrower.  If the builder is not a corporation, they will get a 1099 at year’s end for the contract amount.  No 1099s to corporations.

Construction Loan Appraisals

May 10, 2010 by · 1 Comment 

For a construction loan, the appraisal is done from the plans and cost breakdown.  To call it a “future value appraisal” is a misnomer in some ways since the comparable sales reflect the current market, and no attempt is made to peek into the future.  The appraised value should reflect what the property would be worth if it existed already and was built as planned.  Comps should be similar in design, appeal, effective age, square footage, amenities, and room count and of course should be in the same market area.  Like with other residential appraisals, the comps should bracket the subject properties from the high and low side in most if not all of these areas.   

There are two additional important areas of discussion on construction loan appraisals, the cost approach and the possibility of the property being and over-improvement for the area.  The cost approach is important because construction loans universally are back to where they were 10 years ago, to the extent that value is the lesser of total cost or the appraised value.  Correspondingly, an 80% loan would be based on the more restrictive of loan-to-cost or loan-to-value calculations.  If the borrower is buying the lot, costs are the purchase price of the lot, plus hard and soft construction costs.  Soft costs include plans, plan check, permits, testing and other fees (school fees for example).  If you already have owned the lot for at least a year, the lot value to be used in the loan-to-cost calculation is the lesser of the purchase price or the current value.  No separate lot appraisal will be done.  In the cost approach section of the construction loan appraisal there are numbers for the “site value”, and “as is value of site improvements”. The sum of these two numbers is what is generally used as the current lot value, although sometimes “as is value of site improvements” gets left out.  If the borrowers have done site improvements such as grading or putting in well and septic, the amounts for this work do not get added to the total cost calculations since they should be reflected in “site value” and “as is value of site improvements.”  Softs costs need to be documented with cancelled checks and invoices, and hard costs will be reflected on a fixed price contract with the builder.  Usually the market approach value is higher than the cost approach total, otherwise the borrower might not even be inclined to proceed.

One instance where costs would likely exceed appraised value (based on market comps) is where the property is an over-improvement for the area.  It is hard to get a construction loan on a property which will end of being one of the largest in the market area, unless the borrower starts with considerable equity.  Borrowers may be paying $200 per square foot for additions when appraisers feel constrained to limit GLA (gross living area) adjustments to $100 per sf or less.  This can result in appraisal issues, as can extensive high end remodels without adding square footage.

Builder Approval

May 7, 2010 by · Leave a Comment 

To be an approvable builder, the builder must be a licensed GC in the state where the property is being built.  They must have “happy homeowners” for references, presumably based on jobs similar in scope to the new construction project for which they seek approval.  Vendor and bank references are sometimes required as well.  A credit check is usually done.  IRS liens are one area of concern, since the construction lender doesn’t want the IRS seizing bank accounts and stopping the project.  The builder should have performed the previous work for their own company, not as the superintendent or employee of someone else’s company.  If a builder cannot be approved, most homeowners would not want to use them anyway.

How Methods of Construction Affect Construction Lending

April 30, 2010 by · Leave a Comment 

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.

Types of construction loan builder contracts

April 16, 2010 by · Leave a Comment 

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.