Commercial Loans Blog

Loan-to-Cost Ratio and Commercial Construction Loans

Posted by George Blackburne on Sat, Jul 6, 2013

This is the second of four blog articles that I will write on the subject of the loan-to-cost ratio in commercial mortgage finance.  You will recall that last week I wrote an article on how to compute total cost.  Later this week I hope to write a blog article on the loan-to-cost ratio in renovation finance and a second blog article on the loan-to-cost ratio during times of economic turmoil.

By the way, if you happened to find this article because you were looking for a commercial construction loan, you can submit your commercial construction loan request to hundreds of hungry commercial construction lenders by clicking the button below:

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Today we are going to talk about the loan-to-cost ratio in commercial construction lending.  The Loan-to-Cost Ratio is defined as the (construction) loan amount divided by the Total Cost of the project, times 100%.

Suppose an experienced and reputable developer came up to you and said, "Listen, I want to build a $2 million apartment building.  I almost have enough cash on hand to build it entirely without outside financing.  All I need for you to do is to loan me $800,000.  I'll give you a first mortgage on the apartment building at an attractive interest rate, and before I spend one penny of your money on the project, I will first spend $1.2 million of my own dough getting the property 60% completed.  You can even control your $800,000 so you can be sure your money will be used to complete the project."

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So ... would you do that deal?  Heck, yes!  The developer is the one taking most of the risk, and if he doesn't pay you, you can foreclose on a $2 million apartment building.  You kind of knew that intuitively, but how would you know that mathematically?

Well, let's compute the Loan-to-Cost Ratio.  Eight hundred thousand dollars (the construction loan amount) divided by $2 million (the Total Cost) times 100% gives you a Loan-to-Cost Ratio of just 40%!  The developer is covering a whopping 60% of the cost.  This is a wonderful loan!

Okay, but we're dreaming here.  No developer in real life is ever going to cover 60% of the total cost.  So what is a reasonable Loan-to-Cost Ratio?  During normal times, commercial banks - the lenders who make 95% of all commercial construction loans - will usually make commercial construction loans at 80% of cost.

During go-go times, when commercial banks are cutting each other's throats to get business, commercial construction loans of 90% loan-to-cost were not uncommon.  If the developer was VERY wealthy and VERY experienced, the commercial bank might even lend up to 100% loan-to-cost.  Of course, many of those commercial banks who went 90% to 100% loan-to-cost subsequently failed during the next real estate recession that seems to hit every seven to twelve years.

Today we are climbing out of the Great Recession.  Commercial banks caught in commercial construction loans during the Great Recession got mauled, so during the Great Recession almost all commercial construction financing disappeared.  Even today, very few commercial banks are actively competing for construction deals.

Nevertheless, the economy is recovering.  Construction loans are usually very, very profitable for banks, and they are short term loans.  A few commercial banks today are once again dipping a toe into the construction loan waters.

So what is a reasonable Loan-to-Cost Ratio today?  Today few commercial banks will make commercial construction loans in excess of 65% to 70% loan-to-cost.  In other words, the developer has to cover 30% to 35% of the Total Cost. 

The good news is that, as the recovery becomes more convincing, commercial banks will start to compete against each other for good deals.  I predict that within six months commercial construction loans of 75% loan-to-cost will become commonplace.

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