Commercial Loans and Fun Blog

Structuring Commercial Renovation Loans

Posted by George Blackburne on Tue, Jan 13, 2015

office_constructionOkay, so your client buys a vacant office building from a bank that took the property back in foreclosure.  In other words, the vacant office building was an REO of the bank, which stands for "real estate owned".  If you look at a financial statement of a bank, you will often see a line item entitled, "Real Estate Owned".  The term sounds fancy, but an REO is nothing more than a foreclosed property still owned by the bank.  In order to discourage banks from becoming major property owners, federal regulators financially punish banks for keeping REO's on their books for too long.  This punishment is why banks are always so anxious to clear REO's off their books.

Anyway, now your client needs money to renovate this vacant office building.  He will also need money to make his monthly mortgage payments on the property as he tries to lease it out.  Your client will also need money to finish the tenant improvements and to pay for the leasing commissions. The key thing to remember about commercial renovation deals is that the property is usually not generating any rental income, so the property alone cannot initially afford to make regular montly payments.  We therefore need to build in a reserve for the interest payments on the mortgage during the period that the property is being renovated and leased out.

Commercial loans to make major renovations to income property should therefore be structured just like a commercial construction loan.  You will recall that commercial construction loans are structured with an initial interest-only period, during which time the building is built and leased out.  During this interest-only period, the borrower is only required to pay interest based on the amount of his construction loan that he has actually drawn down.  An example will make this clearer.

Suppose the bank loans the borrower $2 million to build a spec office building, in other words, an office building built on speculation without any pre-leases.  In month one the borrower draws down $75,000 to pay his demolition subcontractor to remove an old building and to pay his grading subcontractor to level and compact the ground.  Therefore, at the end of month one, the borrower only has to pay for one month's interest on $75,000.  During month two the borrower draws down another $100,000 on his construction loan to pay the concrete guy for pouring the foundation.  Therefore, at the end of month two, the borrower has to pay for one month's interest on $175,000.  And so on.


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This is how construction loans are structured.  At the end of the construction loan term, the entire loan either balloons or rolls into some sort of takeout loan.




Training reminder:  A permanent loan is just a first mortgage loan, with a term of at least five years and with some sort of amortization, usually based on a 25-year amortization.  In other words, every monthly payment includes at least some repayment of principal.

A two-year or five-year first mortgage loan with interest-only monthly payments is considered a mini-perm.  Most mini-perms have terms of just two or three years.

Interest-only loans with terms of less than two years are called bridge loans

A takeout loan is just a permanent loan used to pay off a construction loan.  Every takeout loan is a permanent loan, but not every permanent loan is a takeout loan.  Whaaat?  Think about it.  A permanent loan is only called a takeout loan if it is used to pay off an existing loan that was used to build the property.  What if the existing loan was used to simply buy an already completed building?  A permanent loan used to pay off another permanent loan is just another garden-variety permanent loan.  Got it? 




Okay, let's try to remember where we were.  Our borrower owns a vacant office building, and he needs a loan to renovate it and lease it out.  We also said it wasn't generating any income right now.  The way to underwrite and finance such a project is to structure it as commercial construction loan.

From the proceeds of the loan, the borrower would obtain the following:

  1. Money to pay off the bridge loan used to acquire the REO
  2. Hard costs of renovation
  3. Interest reserve during the renovation and leasing period
  4. Tenant improvement costs
  5. Leasing commissions
  6. Soft costs of the renovation loan, including loan points, closing costs, building permits, architectural and engineering fees.
  7. Very large Contingency Reserve.  The typical renovation costs twice as much as projected!




"That all sounds great and everything, George, but clearly the renovation loan lender (construction lender) is not going to lend 100% of the renovator's costs.  The renovator is going to need some skin in the game, right?"

Exactly.  Here is how you tell if your borrower's renovation loan is likely to get funded.  First, you compute the Total Cost of the project by adding up all of the following costs:

Purchase price of the vacant office building
Original closing costs
Hard renovation costs
Tenant improvement costs (probably a reserve)*
Projected leasing commission*
Interest reserve for renovation and leasing period
Soft costs of the renovation loan
Contingency reserve

*Your leasing agent can help you with these numbers.

Your construction lender (renovation loan lender) will probably limit his loan to 75% to 80% of the total project cost.  This is known as the Loan-to-Cost Ratio.  Your renovator/borrower will have to be able provide cash or proof of prepayment of the rest.

The lender will also subject the deal to a Debt Service Coverage Ratio analysis based on the projected rents and expenses in the Pro Forma Operating Statement, but interest rates are so low today that almost all deals cash flow comfortably.

The Loan-to-Value Ratio must also not exceed 70% to 75%, based on finished and leased value of the property, known as the Stabilized Fair Market Value.  Most REO's, however, sell at such large discounts that the LTV is unlikely to be a problem.

If you want your construction loan (renovation loan) to fund, my advice is to concentrate on documenting the costs that your borrower has pre-paid.  Your deal will turn on whether he can show that he is contributing 20% to 25% of the total cost of the project.

The good news is that the economy is booming, companies are expanding, and banks make a ton of dough on construction loans.  Renovation loans, structured like construction loans, are also far less risky than ground-up construction loans for the bank because the walls and the roof on your property have probably already been errected.

To submit your renovation loan (or any commercial real estate loan) to our 750 hungry commercial lenders, simply click on the button below:


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C-Loans, Inc. is also now offering business loans not secured by real estate.  We closed an interesting $300,000 deal last week with a peer-to-peer lending platform, which is just a fancy way of saying a tiny syndicate of private investors.  Just like private investors invest in the hard money commercial loans originated by my hard money mortgage company, Blackburne & Sons, private investors are now making business loans directly to small businesses, in effect cutting out the bank.  We actually closed one such deal last week, and the wonderful thing is that business loans usually close in less than ten days!  


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Wow!  Last week I wrote a blog article about Deflation and Negative Interest Rates.  That article was re-Tweeted five times, shared on Facebook twice, and shared on Linked-In a whopping 29 times.  Thanks, guys.  That meant a lot ot me.

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Topics: Commercial Renovation Loans