Chapter 12 - Construction Loans

1. Chapter 12

Construction Loans

2. Construction Loans

Construction loans are one type of open-end loan

Loan funds are advanced in stages, not all at closing

Deed of trust secures future advances, up to stated maximum loan amount

3. Construction Loans: Loan Terms

Construction loans are short-term or "interim" loans

Term usually based on projected construction schedule

9 - 12 month term common for single-family

12-24 months common for apartments, other commercial properties

Lenders typically use conservative Loan-to-Value ratios

75% LTV or less is common

4. Construction Loans: Interest

Construction loans are typically interest only

Interest is charged on the outstanding loan balance each month

Since loan amount increases over loan term, interest increases each month

Interest rate is typically adjustable rate

Prime rate plus margin is commonly used

Loan amount may include interest reserve or borrower will make monthly interest payment

If an interest reserve is included, interest is deducted from the reserve as earned

5. Construction Loan Appraisals

Construction loan amounts are typically based upon a loan-to-value ratio that uses the "as completed" property value

Borrower submit will submit construction plans, specifications, and a cost breakdown to provide information on the type and quality of improvements

Appraiser will value the property based upon the land value plus the estimated value of improvements, assuming that the improvements are constructed as set forth in the plans and specifications

6. Construction Loan Risks

Construction loans typically present a higher risk than loans made on completed properties

Additional risks:

improvements may not be completed

faulty construction

mechanic's liens

cost overruns

7. Reducing Lender Risk

Lender risk can be minimized by:

Controlling disbursement of loan funds

Goal is that lender will always have sufficient funds remaining to complete construction

Holding back contractor's profit

Getting lien releases

Getting title insurance endorsements before each disbursement

Getting completion and payment bonds

8. Construction Loan Borrower

The borrower on a construction loan may be either the future home owner or a builder

When the home owner is the borrower, usually:

the borrower already owns the lot

the borrower will have a construction contract with a builder to construct the home

loan funds will be used to pay the builder

When the builder is the borrower, usually:

the builder already owns the lot

the future home owner is unknown

9. Combination Loan

Construction loans made to the home owner borrower may be combined with a long-term loan that begins when construction is completed

Also called a construction-permanent loan

During construction loan period, borrower pays interest only

When construction loan period ends, loan converts to an amortized loan

10. Underwriting Construction Loans to Builders

Source of repayment of loan is the sale of the property to a future buyer

Builder loans are sometimes called "speculative" loans because the buyer is not identified at the time the loan is made

Lender is not looking at the builder's income as the source of repayment

Builder's financial condition and credit are analyzed more to determine if builder can pay for any cost overruns, can carry loan interest until property is sold, and pays vendors on time

Lenders typically also look at the builder's experience when reviewing the loan

11. Underwriting Construction Loans to Homeowners

If lender is providing construction loan only, will typically require take-out loan commitment from another lender

Second lender commits to provide loan to borrower when construction is completed

Take-out loan is the source of repayment

Construction lender is less concerned about the homeowner's qualifying ratios

Lender will also review construction contract and builder's experience

12. Underwriting Construction-Permanent Loans to Homeowners

Lender will typically underwrite permanent loan using standard borrower qualifications

Income ratios, credit, and reserves

Lender will review construction contract, builder's experience for construction loan risks

Construction loan LTV may be lower than permanent loan LTV

13. Construction Loan Advances

Loan funds are advanced based on completion of improvements

Loan advances can be made according to a predetermined schedule based upon stages of completion or based upon percentage of completion of line items on the construction cost breakdown

Advances are also called disbursements, draws, or payouts

Rules for construction advances are typically set out in a loan document called a "building loan agreement" or "construction loan agreement"

14. Typical Construction Loan Disbursement Process

Borrower applies for disbursement

Lender inspects property and determines percent of completion

Lender advances funds to borrower or jointly to borrower and contractor to pay construction costs based on construction progress

Lender holds back some percentage of loan until after construction is complete and no liens filed

Example: a 10% holdback is common

15. Construction Loan Agreements

Lenders will use a promissory note and deed of trust for construction loans

Construction loans also use a building loan agreement, which:

Determines how and when loan funds will be disbursed

Describes conditions to disbursements:

lien releases, title endorsements, inspections, percentage of completion

16. HUD Building Loan Agreement Disbursement Process

17. HUD Building Loan Agreement

Condition regarding mechanic's liens, payment

18. HUD Draw Request Form

Draw Request Form

19. Blanket DOT and Partial Releases

Lender may have a deed of trust that encumbers several parcels of land

Often called a "blanket deed of trust"

Common with loans for new subdivisions

Borrower will want a right to release individual parcels from the lien of the deed of trust when construction on that parcel is complete

Called a "partial release" clause

Building loan agreement often has requirements for partial releases, including amount borrower must pay to release individual parcels

Often more than 100% of the pro rata loan amount

20. Partial Release Example

Blanket deed of trust encumbers 4 lots

Loan amount $1 million

Borrower sells Lot 1 for $350,000

Lender requires partial release payment of $300,000

21. Mechanic's liens

Persons who provide materials and labor to improve real property have a right to place a lien against the property for the value of the materials or labor

If not paid for their work, claimants can file a mechanic's lien, giving the claimant the right to sell the real property (foreclose) to get paid

Right to claim lien and right to enforce lien are both subject to compliance with statutory filing deadlines

22. Mechanic's liens deadlines

First deadline: filing preliminary notice:

Does not apply to contractors (someone with a direct contract with the owner) or to laborers

Applies to all others (for example, subcontractors and material suppliers)

To preserve the right to claim a lien at a later date if not paid, those required to file a preliminary notice must file no later than 20 days after starting work

23. Mechanic's liens: second deadline

Second deadline applies to all mechanic's lien claimants

Claimant must file mechanic's lien no later than the following dates:

If owner files a Notice of Completion:

Contractor (with direct contract with owner) must file within 60 days after notice of completion filed

Others (subcontractors, material suppliers, laborers, etc.) must file within 30 days after Notice of Completion filed

If owner does not file Notice of Completion:

All must file within 90 days from substantial completion of property

24. Mechanic's liens: Third Deadline

Deadline for enforcing mechanic's lien applies to all mechanic's lien claimants

Claimant must file action to foreclose within 90 days after filing mechanic's lien claim

Foreclosure action is to force the sale of the property and use the proceeds of the sale to pay the claim

25. Mechanic's liens: relation back

All persons who file a mechanic's lien on a timely basis have priority date back to the date work first started on the project

All lien claimants who foreclose share in the foreclosure proceeds in proportion to their claims

Mechanic's liens can have priority over deeds of trust that are recorded after the work started, but before the mechanic's lien is filed

26. Mechanic's Lien Doctrine of Relation Back

27. Terminating Mechanic's liens

Mechanic's liens can be terminated by:

Payment of claim

Claimant must file release of lien

Example text page 330


Failure of claimant to file for foreclosure within 90 days after filing lien

28. Notice of Nonresponsibility

An owner who is not contracting for improvement of the owner's property can file a Notice of Nonresponsibility to protect the owner's property interest from mechanic's liens

Sample Notice of Nonresponsibility, text page 329

Notice of Nonresponsibility typically used only when a tenant is making improvements

Tenant is responsible for paying claims and mechanic's liens can be filed against the tenant's leasehold interest in the property

29. Assessment Liens

Public agencies may build public improvements that benefit property and place lien on property for payment of costs

Special assessments are collected with, and have same priority as property taxes


Mello-Roos Community Facilities Act

Street Improvement Act of 1911