Starting a new construction project for your business is exciting but let’s be real – managing the upfront costs of materials, permits, and labor as a small business can be a tough hurdle. Fortunately, there’s a way to leap over it without draining your cash flow. Commercial construction loans allow small business owners the opportunity to build without breaking the bank upfront. Learn how to navigate the complexities of how these loans function, understand the nuances of different loan types and gain professional insights on the qualifications necessary for securing the financial foundation of your project.
What is a Commercial Construction Loan?
A commercial construction loan is a financing solution designed specifically for businesses undertaking construction projects. Unlike typical mortgages, which fund property purchases, a commercial construction loan focuses solely on financing construction expenses.
Benefits of Obtaining a Commercial Construction Loan
The benefits of obtaining a commercial construction loan include:
- Flexible terms: Commercial construction loans offer flexibility to align with the project’s timeline. This allows borrowers to tailor repayment schedules and terms according to the construction timeline.
- Funds entire project: Commercial construction loans provide the necessary funds for entire construction projects covering costs like material, labor, permits, and other associated costs.
- Collateral flexibility: Many commercial construction loans offer flexible terms of collateral, allowing borrowers to leverage the project itself or other assets as security.
- Streamlined approval process: Lenders experienced in commercial construction loans often have a streamlined application process.
Types of Commercial Construction Loans
SBA Loans – 504 & 7(a)
The Small Business Administration offers government-backed loans like the 504 and 7(a) which are popular choices for small business owners, offering down payments and competitive rates. The SBA 504 loan program provides up to $5 million in funding, primarily for real estate and equipment purchases. There are long repayment plans available up to 20 years, making it a favorable option for businesses with substantial capital needs.
The SBA 7(a) loan program is versatile, supporting a wide range of purposes, including working capital and expansion. The 7(a) loan program provides up to $5 million in funding with reasonable repayment terms. Both programs aim to help small businesses grow by easing financial stress, making them both attractive solutions for entrepreneurs seeking accessible and affordable financing solutions. You can learn more if an SBA loan is a right fit for your construction business here.
Business Loans from Banks
Banks are a common option for obtaining a commercial construction loan offering variable rates, repayment terms, and down payment requirements. Typically, a minimum down payment of 10% is standard. Repayment terms can extend up to 25 years, providing flexibility for managing long-term financial commitments associated with big construction projects. These loans can be used for various purposes, including working capital or smaller equipment purchases.
Working Capital Loans from Alternative Lenders
Working capital loans from alternative lenders can fund commercial construction projects by covering the costs of insurance, permits, labor, or supplies and materials. These short-term loans typically last 18-24 months. Most alternative lenders prefer businesses that have been operational for at least 6 months with good credit scores, and an annual revenue of $250,000 or more. Alternative lenders often consider a broader range of factors beyond traditional credit scores, accommodating businesses with shorter operational histories. Working capital loans from alternative lenders appeal to those who seek immediate access to funds without wanting to navigate the strict requirements of banks.
Heavy Equipment Financing
Small business owners can leverage heavy equipment loans to acquire the essential machines and tools required for their construction project. This allows them to secure the necessary assets without a significant upfront cost. The types of equipment that can be financed include manufacturing equipment, construction tools, office machinery, and any tech hardware.
By using the newly acquired equipment as collateral, small business owners can enjoy several benefits. Heavy equipment financing simplifies the loan approval process because the equipment serves as a tangible asset that can mitigate the lender’s risk. Leveraging equipment allows for more favorable terms compared to unsecured loans. Additionally, this financing approach enables businesses to conserve working capital for other operation needs while still obtaining the crucial assets vital for the business’s success.
Qualifying for a Commercial Construction Loan
1. Credit Score and History
A strong credit score and history play a pivotal role in qualifying for a commercial construction loan. Lenders assess creditworthiness by reviewing the applicant’s credit history, payment patterns, outstanding debts, and credit utilization. Typically, lenders prefer borrowers’ credit to be above 650. A higher credit score offers several benefits, including lower interest rates and more favorable terms. Lenders view a higher credit score as an indicator of responsibility and reliability.
2. Liquid Assets and Cash Flow
For small business owners seeking a loan, showcasing financial stability is key. Lenders examine a few vital factors to assess cash flow, including monthly revenue, expenses, and net income.
- Average monthly revenue: Consistent and solid revenue illustrates that your business can bring in money, assuring lenders of your ability to handle loan payments.
- Expenses: This includes everything from day-to-day operations to existing debts. It helps lenders gauge how well you manage your financial responsibilities.
- Net income: This is the revenue minus expenses. A positive net income is a green flag, telling lenders you’re in good shape and capable of making loan payments.
Having liquid assets on top of these adds an extra layer of security. These assets serve as a financial safety net, proving to lenders that you’re ready for any unexpected twists.
3. Debt Service Coverage Ratio (DSCR)
The Debt Service Coverage Ratio is a formula that helps lenders decide if your business makes enough money to cover its loan payments.
DSCR= Net Operating Income/Debt Service Payments
Your Net Operating Income is what your business makes before dealing with interest and taxes and Debt Service Payments cover your loan’s principal and interest.
If your DSCR is above 1, it means you’re juggling your debt payments well, making more than enough to pay off your debts. Lenders love this because this means you’re in great financial shape and less of a risk for them.
4. Profit and Loss Statements
Lenders use profit and loss statements to see how healthy your business is financially and its ability to repay a loan. When applying for any commercial construction loan, be sure to have your most recent profit and loss statement and tax returns. Having these documents shows that your business follows tax laws and has a good track record of managing finances well.
5. Detailed Construction Plans
When seeking a commercial construction loan, it’s not just about numbers. Lenders want to see a clear picture of your project. Share blueprints and floor plans to show the lenders exactly what you’re building. Break down the project completion timeline. Specify supplier and labor costs to lenders with a clear expense breakdown.
6. Type of Property Being Developed or Constructed
When deciding what type of property to develop or build, a small business owner should think about the location, what the local market needs, and how they plan to use the space. The type of property you choose affects your chances of getting a commercial construction loan. Lenders look at factors like how in-demand the property might be, potential income, and their experience. Properties with a proven track record of being in demand and generating consistent income are seen more positively by lenders. Small business owners commonly use commercial construction loans to finance projects, office spaces, retail stores, or industrial facilities like a factory.
7. Qualified Builder
A qualified builder should not only have a proven track record but also be associated with reputable contractor groups. Here’s a list of the qualifications and documentation required to prove the builder’s credibility:
- Association membership
- Licenses and certifications
- Client references
- Proof of insurance
- Proof of financial stability
8. Down payment
A down payment is an upfront sum paid by the borrower that helps reduce the lender’s risk. It shows the lender your financial commitment to pay back the loan. In return, the lender may offer you a lower interest rate.
Typically, a 10% down payment is common for construction business loans. However, it’s important to note that this percentage can vary up to 20-30% depending on how risky the lender believes your project is. The bigger the down payment, the less risk the lender takes on.
9. Collateral and Personal Guarantee
Lenders want assurance that if things go south and there’s a default on the loan, they have something to recover their investment. This assurance comes in the form of collateral. Collateral can be equipment, inventory, accounts receivable, or properties – whether they’re being purchased, developed, or renovated.
A personal guarantee is a personal commitment from the business owner. It holds the business owner directly responsible for repaying the debt. If the business cannot repay the loan, the lender can go after the owner’s assets. This adds an extra layer of security and shows the lender the significance of the business owner’s commitment to the loan.
About the Author
Pretha Yasmin is the consumer analyst for SmallBusinessLoans. She has more than five years of experience in marketing and studying consumer behavior for a wide range of industries including finance, construction, and hospitality. She holds a Bachelor of Business Administration in marketing from Brooklyn College.