Construction Financing: How Construction Financing Works

Picture this: You just broke ground on a new construction project. Everything is going according to plan, and your budget is right on track. But right as you settle in for a smooth journey, there’s a supply chain issue. And a payment dispute. And a permit delay. All of a sudden, you’re drowning in extra costs and can no longer afford to finance your building expenses.

What starts out as a feasible commercial construction project can turn into a mountain of expenses at any turn. Even without unexpected expenses, it can be difficult to procure funding for a project to begin with. That’s why it’s important to secure construction financing that prepares you for anything.

But where to begin? There are many routes to consider in the complex landscape of lending, each with its own benefits and risks. In this guide, we’ll help you determine the best commercial construction financing option for your business.

What Is Commercial Construction Financing?

Commercial construction financing is a type of loan or financial agreement specifically designed to fund the construction of commercial properties. This includes office buildings, retail centers, warehouses, and other business-related real estate projects. It’s an essential form of financing for developers and businesses looking to build new structures or renovate existing ones. The right financing can help cover the costs of land acquisition, construction materials, labor, and other related expenses to see your project through from start to finish

So, how does it work? Commercial construction loans are typically dispersed in stages according to a draw schedule based on certain milestones during the progress of the construction. This staged disbursement helps manage cash flow effectively, ensuring that funds are available as needed while avoiding unnecessary debt accumulation. Most lenders will allow you to pay only interest on the amount you’ve drawn to date and structure it so that the remainder of your balance is due when your project is complete.

Several key criteria are evaluated by lenders to determine the eligibility and terms of a given loan. Here are some of the most important factors:

• Cash Flow: Lenders assess the borrower’s cash flow to ensure they can make timely interest payments during the construction phase and later repay the loan. This involves reviewing financial statements, cash flow projections, and the overall financial health of the business. Strong, consistent cash flow indicates lower risk for the lender.
• Down Payment Requirements: A down payment demonstrates the borrower’s commitment to the project and reduces the lender’s risk. For commercial construction loans, down payments usually range from 10% to 30% of the total project cost. The exact amount can vary based on the type of loan, the lender’s policies, and the borrower’s creditworthiness.
• Loan-to-Cost (LTC) Ratio: The LTC ratio is the ratio of the loan amount to the total cost of the project (including land acquisition, construction, and other related expenses). It helps lenders determine how much equity the borrower has in the project and ensures that the borrower has a significant financial stake, reducing the likelihood of default. Lenders typically finance 70% to 90% of the project cost, meaning the LTC ratio can range from 70% to 90%. The higher the LTC ratio, the higher the risk for the lender.
• Property Appraisal: An independent property appraisal is crucial to determining the property’s current market value and potential future value upon completion of the construction. The appraisal helps ensure that the project is financially viable and that the property’s value will sufficiently cover the loan amount. It also protects the lender by providing an objective assessment of the property’s worth. Property appraisers consider factors such as location, market conditions, comparable property values, and the quality of the planned construction.

What Are The Benefits Of Commercial Construction Financing?

​​Securing financing for a commercial construction business can be a game-changer. Let’s take a look at some of the key benefits financing can provide during the construction process and beyond.

1. Access to Capital: Financing provides the necessary capital to start and complete construction projects without depleting your business’s own resources. This enables your business to take on larger projects and multiple ventures simultaneously, fostering growth and expanding opportunities.
2. Improved Cash Flow Management: Construction loans are typically disbursed according to a draw schedule aligning with the project’s progress. This staged disbursement helps manage cash flow effectively, making funds available when needed while minimizing interest costs and financial strain.
3. Leveraging Investment: With financing, businesses can undertake projects worth significantly more than their available cash reserves. Leveraging investment this way allows for more ambitious projects and higher potential returns on investment.
4. Preservation of Working Capital: Financing helps preserve steady working capital, enabling businesses to maintain liquidity and invest in other critical areas such as marketing, staffing, and other necessary internal operations.
5. Enhanced Project Viability: Lenders typically require thorough project plans, budgets, and feasibility studies before approving financing. This scrutiny reinforces the viability of projects, making sure they’re well-planned to reduce the risk of delays, cost overruns, and failures.
6. Increased Property Value: Financing supports the development of new structures and the renovation of existing ones, significantly increasing the property’s market value. Higher property values can lead to increased rental income and better resale value, creating a stronger financial position for the business.
7. Competitive Advantage: With access to financing, construction businesses can take on and complete projects more quickly and efficiently, gaining a competitive edge in the market.

Financing Options for Commercial Construction

There are many ways to secure commercial construction financing. Let’s explore some of the most common routes to determine which one is right for your business.

Traditional Bank Financing

Traditional bank loans for commercial construction typically come with fixed or variable interest rates and payment periods ranging from 5 to 25 years. Funds are usually disbursed according to a draw schedule, and the property under construction often serves as collateral. Lenders look for strong credit scores and credit history, and a down payment ranging from 10% to 30% of the total project cost is typically required. A detailed business plan and project proposal, including budgets, timelines, feasibility studies, and demonstrated cash flow to cover loan payments, are essential.

SBA Loans

Small Business Administration (SBA) loans are partially guaranteed by the U.S. government, making them less risky for lenders and more accessible for borrowers. They’re designed to be accessible to small businesses that might not qualify for traditional bank loans due to lower credit scores or limited collateral.

Commercial construction owners might choose SBA loans because they offer longer payment terms and interest rate caps. They don’t require business owners to sacrifice business equity to get the loan, and most of them are backed up to 85% should the small business owner default on their loan. The two main types of SBA loans typically used for commercial construction are the 7(a) loan and the 504 loan.

Non-Traditional Options

One non-traditional finance method is crowdfunding. Crowdfunding involves raising small amounts of money from a large number of people, typically through online platforms like Kickstarter or Indiegogo. It should be considered for unique or community-focused projects that can generate public interest and support. Crowdfunding can be helpful for businesses looking to build brand awareness and engage with potential customers early on.

Another less conventional option is friends and family loans, which involve borrowing money from personal connections. These can be considered when traditional financing is not accessible and the borrower has strong personal relationships who are willing and able to invest. Clear terms and formal agreements are crucial in these situations to avoid potential conflicts.

Revenue-Based Financing

An alternative financing option to the ones above is revenue-based financing (RBF). With RBF, lenders provide working capital in exchange for a percentage of the business’s future revenue with a daily or weekly payment structure. RBF is based on the revenue that the business generates monthly.

Unlike traditional loans, there is no fixed payment term with RBF. While traditional loans require some type of collateral, RBF does not. This makes it accessible to businesses with limited assets. Because RBF focuses more on revenue potential rather than credit scores or collateral, low credit scores will not bar you from securing financing.

Application and Qualification Process with Mantis Funding

How to Qualify for RBF: To qualify for RBF with Mantis Funding, your business must have been operational in the U.S. for more than 6 months, and you must own 50% or more of the business. Your business must also pass a minimal credit score check, but keep in mind that low credit scores are acceptable. Fill out an application and get notified by the Mantis Funding team within 24 to 72 hours if your business has been approved for financing.

Understanding Credit Scores and Funding Eligibility: While there’s no single credit score requirement, some lenders propose a minimum threshold. Depending on the lender, a score in the mid-600s range is often considered an ideal benchmark, but at Mantis Funding, low credit scores are OK! At Mantis Funding, our team considers your entire financial picture – including business cash flow, profitability, and experience in the construction industry.

Navigating Challenges and Solutions

There are many financial hurdles to overcome during commercial construction projects, and they can significantly impact your finances. Some typical challenges include cost overruns, cash flow shortages, delayed funding, fluctuating market conditions, and stringent loan requirements. Without financial support tailored to your circumstances, these issues and more can set your progress back or force you to abandon your project altogether.

With Mantis Funding’s problem-solving expertise, you can rest easy. Our team is experienced in construction financing, so we know what it takes to help you overcome common financial challenges. Every project is different, so Mantis Funding prioritizes customized, flexible solutions for your exact needs. Our streamlined approval process reduces delays in funding and helps keep you on schedule, prepared for the unexpected.

Conclusion

Financing a construction project is a complex issue, and there are many ways to go about it. With an understanding of the different commercial construction financing options, you’re equipped to make the best decision for your business. Contact Mantis Funding today or apply now to get expert help with tailored financing solutions for your construction projects.

About Mantis Funding

Mantis Funding is a business financing solutions firm catering to small and mid-sized business owners in the United States.