Construction Business Loans for Homebuilders
It could be years before a homebuilder sells their first house from the time they acquires the land through construction. To cover all of those expenses, most home builders will need to borrow money.
Homebuilders typically finance 100 percent of their construction costs, usually through banks or investors, said Kevin Booth, chief financial officer of Las Vegas-based construction company WestCor Companies and treasurer of the Construction Financial Management Association. Construction loans help homebuilders finance the cost of developing new neighborhoods.
According to Booth, banks often view the housing market as risky and are hesitant to loan money to small home building businesses, instead preferring to work with large, publicly traded companies with an established sales history, like KB Home, one of the largest homebuilders in the country.
“One of the reasons the public builders have taken off is because it’s much easier for them to get capital for construction,” Booth said.
However, private homebuilders can still find the funding they need to build and sell houses. We’ll walk you through the construction financing available to homebuilders and how you can access money to get your business off the ground.
The ins and outs of running a home building company
The first step for homebuilders is finding an area to build a new development, Booth said. You’ll need to consider local zoning ordinances and environmental regulations before purchasing the land. Endangered species, wetlands and water quality in the surrounding area could affect whether or not the land is suitable for a home.
The next step would be outlining your engineering and development plans, said Booth. You’ll decide where the house lots will be located, as well as roads, lighting and signage. You must also submit your plans to city or county offices for approval, he added.
“Once you get that approved, then you’ve got to start construction of that development,” he said.
Setting up utilities should be first on the list, including gas, water and electricity. You would then clear the land to make streets and gutters, then add exterior landscaping for the community, Booth said.
Next, you’ll hire subcontractors to begin construction on houses, Booth said. Most private homebuilders choose to work with subcontractors rather than doing all of the construction themselves, he said. You may need to acquire permits to carry out electrical and plumbing work on the properties.
All of this work needs to be done before you make your first sale, which is why you would need to obtain financing. In the homebuilding business, there’s a lot of money going out before any comes in, Booth said.
When it’s time to sell your homes and generate some cash, you could put them up for sale individually as they’re completed or list a group of houses in phases, Booth said. You would begin paying off your loans as the houses are sold.
Construction financing for homebuilders
Homebuilders typically obtain two types of financing to cover the different stages of property development, Booth explained. You would finance all of your costs with these loans and repay your debt when you start selling homes.
Acquisition and development loans: These loans cover the purchase of undeveloped land and the components of the overall subdivision, such as streets and sewer lines, which Booth calls “horizontal construction.”
Construction loans: These business loans then cover the process of building the homes in the subdivision, also known as “vertical construction,” Booth said. You would use your construction loan to pay subcontractors, including carpenters, electricians and plumbers, working on each house. Construction business loans can also be taken out for multiple homes at a time and also cover the cost of materials and permits. In some cases, a construction loan may include acquisition costs.
The agreement for your construction loan would describe the terms of your loan and when you’d be expected to pay back your debt, Booth said. For example, if you obtain a construction loan to build 10 houses, the lender would place a lien on all 10 homes. When each home is sold, the lender would receive a portion of the sale price and lift the lien, Booth said.
“Typically, these loans are paid at closing as [houses] are sold,” Booth said. “It helps the homebuilder not have to come out of pocket to pay.”
When you apply for a construction loan you must provide the lender with a forecast of how many homes you expect to sell during a set period of time, such as four homes in one month, Booth said. This is known as your absorption rate and affects the interest rate on your construction loan.
“The slower the absorption rate, the higher the interest rate is going to be because the longer the lender is going to have to wait to get repaid,” Booth said. “They’ll get nervous the longer they have to wait.”
When choosing the location for your development, it’s important to choose a market with high sales velocity so you can sell your homes quickly, Booth said. The absorption rate in the local market would also affect your chance of approval for a construction loan, he said. If home sales in the area have been low, a lender might see the project as too risky to finance.
Approval would also be based on your personal credit history and your projected construction costs. Your projections, for both costs and absorption rate, should be as accurate as possible, Booth said. Back up your claims with data from the real estate market where you’re looking to build.
“Show a schedule of how you’re going to borrow and repay those funds,” Booth said.
Interest rates on construction loans can either be fixed or variable, and are typically tied to the prime rate that lenders offer.
Where to find construction loans
Banks are the most common places for homebuilders to find construction loans, as well as acquisition and development loans. Still, according to Booth, the effects of the housing market crash in 2008 are still being felt at major institutions. A decade ago, homebuilders built too many houses that they couldn’t sell. Banks foreclosed on those homes and had to sell them for a steep discount.
“Banks have been tough because of the recession,” Booth said. “Underwriting is a lot tougher than it used to be.”
Smaller private homebuilding companies may have more luck at community banks or credit unions, noted Booth. Those lenders may have a better handle on the nearby real estate market.
“Your local market might have a lender that’s more conducive to construction loans,” he said. “Every market is a little different.”
Banks may want to see the following from homebuilders:
- Pre-sold units — If a homebuyer(s) has put down a deposit, this is a sign to the bank that the property is less likely to sit vacant for a long period and delay payment.
- Cash or collateral — Lenders will calculate the project’s loan to value ratio, often 70 percent or less.
- Financial history — The homebuilder’s creditworthiness will be a factor.
- Construction period — A shorter construction period will be viewed more favorably by lenders.
In addition to traditional construction loans, builders can partner with buyers on one-time close loans, also called “construction-to-permanent” loans or “all-in-one loans.” Homebuyers typically begin making (interest-only) payments during construction; once the house is complete, the loan is converted to a regular mortgage.
Investors are also a common option for homebuilders, Booth said. You could form a limited partnership with 20 to 30 investors who would cover the vertical construction portion of the development, Booth said. Rather than paying back a construction loan, you would share a portion of profits with each investor.
Some alternative online lenders provide construction loans for business owners to cover equipment, supplies and contractor salaries. Interest rates may be higher than they would be at a bank, but you may not face such strict underwriting requirements.
For example, National Funding offers loans of up to $500,000 for businesses in the construction industry. You can apply for financing online and be approved in as few as 24 hours. Unlike a bank or credit union, National Funding does not rely heavily on your personal credit history when reviewing your application.
The bottom line
Construction loans for homebuilders can be difficult to get because of the rocky history of lending in the housing market. Smaller businesses with little experience often have an even harder time securing financing to build homes.
But, it’s not impossible. You may have a better chance of being approved for a construction loan if you build fewer homes at a time, Booth said. You could obtain financing for just one home or a group as small as four homes, he said.
Once the houses are built, the clock starts ticking to pay back the lender. If you agreed to sell four houses in a month, you must stick to that timeline or risk the lender foreclosing on the property, Booth said.
“These construction loans can mature before you’ve had the chance to sell it,” he said.
You may be able to ask the lender for an extension, which could require you to drop the home price or take other measures to speed up sales, Booth said.
There are several construction loan providers you could work with, including major banks, community banks, alternative online lenders and investors. While several factors would play into your decision, Booth suggests starting at a bank if a low interest rate is your priority.
“My recommendation would be to go a bank first, if you could,” Booth said. “A bank is the cheapest partner you can find.”