5 Steps to construction loan funding

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The essential guide to preparing for the construction loan funding process

If you're in the market for construction loans, it's essential to understand the process and what is required of you. There are many steps involved in securing funding for your construction project, and each one is critical to the success of your endeavour. Prepare yourself for what's to come with these critical aspects of the construction loan funding process.

5 Steps to construction loan funding

Step 1 - Prepare plans and descriptions

Every lender and the lender's engineering consultant should receive a set of plans and specifications for each construction loan.

Prepare plans and descriptions

Plans

Drawings are all that plans are. The most helpful ones to a lender are weighed and placed on sizable sheets of paper. All schematics are not to scale, but others, including those, are utilized in combination.

Working scales change based on the level of information required and the project component being considered. One-quarter inch equals one foot, and three-eighths of an inch equals one foot are the most used scales.

Plans

Plans must be precise and in-depth because you will use them to build the project. Various sets of plans are available based on the intended use. 

  • Architectural plans that outline the project's layout and structure.
  • Electrical plans that outline the project's wiring, lighting, electrical panels, and other components
  • Heating, ventilation, and air conditioning (HVAC) plans
  • Sprinkler and standpipe plans plumbing plans
  • Elevator plans
  • Demolition plans
  • Excavation plans

They are indexed according to type in the lower right corner. For instance, "A" indicates that the viewer is viewing architectural plans, while "E" indicates that the viewer is viewing electrical plans.

There are various forms of plan drawings as well. If you know them, you might inquire about and refer to particular viewpoints that will help you better understand the project.

plan drawing

Plan view, elevation view, sectional view, detail view, isometric view, and schematic view are the different viewpoints. 

  • The plan view, sometimes known as the bird's-eye view, is an overhead perspective that looks straight down at the project. 
  • The project is seen from an elevation view perpendicular to one of its sides.
  • The sectional view examines a portion of the project that may show undiscovered elements. 
  • The detail view is a close-up of a specific area that demonstrates more technical aspects, such as a connection technique or the layered construction of a wall. 
  • An isometric perspective is a three-dimensional view of an object at a 30-degree angle looking up (or down) (there is also an axonometric view from a 45-degree angle).

Accuracy and design detail are typically absent during the construction loan approval procedure to the point where they may be used to start construction. It is true since even the most fundamental structures nowadays have a high level of complexity. Building involves regulatory compliance, which adds to the length of the process.

The architect might not have done much more than create a few rough floor plans and some renderings of the proposed building if the construction loan transaction coincides with the acquisition of the site, which is typical.

Also, the developer may wish to avoid spending and fussing over plans and specifications to have the seller baulk if there is no signed sales contract or he cannot acquire financing. As a result, the original architectural blueprints are frequently employed as a starting point for project development and conceptual objectives. Later, plans and specifications will be prepared if the project goes forward.

Specifications

Plans always have specifications. They can be printed out on paper the same size as the plan drawings or, on more significant projects, they are sometimes maintained in a separate book. 

Plans offer a visual roadmap for how to continue, whereas specifications specify the tools and techniques needed in writing. 

When you request a buildable or comprehensive set of blueprints, you also request specifications. Specifications must accompany plans if they are helpful for anything other than a broad initial conceptual approach.

An organization system is crucial because requirements can be several hundred pages long. An industry organization called the Construction Specifications Institute (CSI) has modified a standard system. 

The system divides specifications into divisions, and each is further divided into subdivisions. Five-digit codes are used to identify the divisions; the first digit (or the second after a zero) designates the division, while the remaining digits designate subdivisions.

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Step 2 - Proceed with the best approach

A property developer can plan and construct a project using one of four fundamental, accepted approaches. These approaches overlap and aren't inseparable. Elements of each are widespread on subtrade-level to whole-job jobs.

Proceed with the best approach

1. Construction management approach

The most well-known method involves the architect being engaged by the developer and producing a set of biddable blueprints and requirements. The owner's construction manager distributes designs and specifications to bidders.

Winners are selected based on cost, expertise, performance history, accessibility, and references. The owner and the contractors enter into contracts. 

The architect stays actively involved in the construction phase by supervising the work through ongoing communication with the management or contractor and regular progress checks. The developer supports cost overruns with this approach.

2. Risk-based construction management approach

The only difference between this strategy and the construction management strategy is that the general contractor assumes the role of independent construction manager in this strategy. 

The general contractor's contract will cover budget overruns brought on by necessary change orders because it has greater control over the project (contracts are between the general contractor and the contractors, not the owner).

The developer, who actively participates in the project's design, hires the architect in both the construction management and construction management at-risk approaches.

3. Design bid build approach

In contrast to the previous approach, the architect is also the construction manager in this one. The architect has the most control in this method, but due to the nature of the business, the developer is typically responsible for the cost overruns.

The architect may have too much power under the design-bid-build methodology. The developer may have significant overruns that are challenging to justify if there is insufficient outside control and he is not proficient in all facets of the architectural and construction management procedures. As a result, it is the least used technique in commercial real estate construction.

4. Design-build approach

The design-build method is quickly gaining favour because, when done right, it shortens the time needed to start and finish a development project, offers more flexibility on-site, and lowers upfront expenses.

The developer, architect, and general contractor collaborate on the conceptual design of a design-build project, but the architect answers to the general contractor rather than the owner. The contractor must pay for cost overruns. 

The design-build method enables simultaneous progress of all three steps, in contrast to the construction management and construction management at-risk techniques, which perform design, bid, and work activities linearly. 

Before completing all project designs and requirements, the general contractor will start working (plans and specifications will be filed with all the applicable municipalities in stages). The project is finished sooner since tasks are carried out in parallel instead of serially.

A potential problem with the design-build method is that there is a higher chance that the general contractor may sacrifice quality to reduce costs and boost profits. 

An important check and balance may be lost if the general contractor controls the architect. Most abuses occur in security and HVAC when quality and capacity are sacrificed for cheaper systems that may fail, require extra care, or need upgrading.

The more complicated and distinctive a project is, the less likely the design-build method will be successful since trades, materials, structure, and function interrelate exponentially with complexity.

As a result, there is a higher likelihood that a crucial factor may be missed or inadequately taken into account. The general contractor's track record of completing similar projects is a key determinant of the design-build method's success.

Step 3 - Properly drafting the construction contract 

Before a building contract is created in its final form and signed, there may be a lengthy procedure, except for easy, routine, or minor work. The sequence of events typically follows something like the description below.

Plans and specs eventually reach a level that contains much clarity and assurance as they go from the conceptual stage. At or before this moment, contractors receive copies to evaluate their piece of the project. 

The architect, engineer, owner's representative, construction manager, and general contractor review the bid process and address general inquiries at a contractors' meeting. Depending on the job, contractors might be given a tour of the property at the same time or close to it to obtain a firsthand look at the work area. 

There are frequently more detailed inquiries and recommendations regarding the plans, building specifications, method of bidding, time frames, and other topics after a meeting and site visit. 

Frequently, the conversation will lead to better goals and requirements, cost savings, and the start of a fruitful collaborative working partnership. 

The developer (general contractor, construction manager, or whoever controls the project) has a deeper understanding of each contractor and an idea of which one will probably work best with him and others on the job as conversations with other contractors go. As a result, the winning bid is not always the lowest one.

After a winning bidder is selected, the developer or contractor drafts a contract, which is then signed by all parties, possibly after some further discussions and revisions. 

A building contract can be well over 100 pages long for higher-level agreements involving, for instance, a general contractor and an owner, as well as larger, more complex, costlier projects, jobs where the parties are unfamiliar with one another and so desire complete protection.

Properly drafting the construction contract

Involving the development lender

The developer should supply the lender and the lender's consultant engineer with the information required to evaluate the development project while he and his team are revising plans and specifications and reviewing, hiring, and contracting trades.

The engineering consultant

The consulting engineer is one of the tools the development lender uses (also called the inspecting engineer, engineer, construction consultant, or engineering consultant). Based on prior experience, senior management at most institutions compiles a short list of approved engineers from which the loan officer may select. 

On a transaction-by-transaction basis, the outside consultant is chosen from the list. There may be an internal engineer who is in charge of examining the work of the external consulting engineer and overseeing his performance in significant institutions that provide numerous construction loans. He might also be in charge of selecting the engineering consultant.

The responsibilities of the engineering consultant

The engineering firm's responsibilities start with a thorough initial assessment, which includes a look at the plans and specifications to determine their breadth and completeness, a look at the principal trade contracts, and a comparison of the construction budget to the scope of work.

The construction's viability is then evaluated in light of the work that needs to be done and the budget and time allotted. Concerns raised by the engineering firm should be communicated to the borrower and resolved.

A loan officer will evaluate multiple initial inspection reports during a typical development lending career and get dozens of periodic inspection reports.

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Using initial plan and cost review

On the surface, the plan and cost review's objectives are as follows:

  • Give some assurance that the engineer did an excellent job reviewing the project (based on how long and in-depth the review was).
  • Give a general overview of the project.
  • Raises questions and worries that need to be answered before construction funding can move forward.
  • Give an opinion on whether or not the developer's budget is fair.
  • Give an opinion on whether or not the developer's time frame makes sense.
  • Talk about any areas that worry you or need more information, as well as the need for more research and analysis.

The budget typically requires the engineer's approval before any construction loan advances may be made. Suppose it isn't, and you can't get the borrower and engineer to agree on their estimates. In that case, you have a few options, including - 

  • Overriding the engineer's advice
  • Rearranging how costs and expenses are allocated in the borrower's budget (e.g., cutting some soft cost expenses if possible and raising hard costs by a similar amount)
  • Lowering the construction loan amount
  • Requiring the borrower to put up more equity.

The building contract with the consulting engineer

A written agreement between the consultant and the lender should be made to prevent, or at the very least, lessen the impact of subpar performance by an engineering consulting business. 

Reviewing the engineer's written proposal typically kicks off this process. It should outline the consultant's responsibilities from the original project evaluation to loan advances and be as detailed and thorough as possible.

Make sure the engineer is aware of the expectations. He should be aware that you, his client, will notify your institution of your unhappiness and might fire him if he doesn't perform well for you.

Issues between the consultant and the borrower

Early on, you must stay in touch with both the borrower and the engineering consultant to ensure everyone is doing their duties. It is often the borrower's fault when problems start before or during a loan. 

  • Numerous potential causes exist: The borrower can turn his focus elsewhere after concluding that your institution has agreed to fund the debt. 
  • He can be angry with the engineer because he feels they are questioning his job. 
  • He can feel that the engineer doesn't recognize how much risk he is exposed to and has already invested a lot of time and money in the project. 
  • Additionally, he is aware that regardless of how well the engineer performs his services, he will be responsible for paying the engineer's expenses through the lending company. According to him, the engineering business only adds to the project's costs without assuming any risk or expense.

You should clarify to the borrower that your institution demands that the engineer be satisfied before you can provide any loan advances if you feel that the borrower is not participating or is uninterested in the engineer for any of these reasons. 

Response times too slow to the engineer's requests may cause funding delays that raise the borrower's costs. More seriously, any early disagreements between the borrower and the engineer may be a sign of carelessness or poor planning on the borrower's part or, worse still, a sign that the borrower lacks the competence required to carry out and finish the proposed construction project. You must make critical choices if you believe this to be the case.

Of course, you may not enter into the loan if it has not yet closed. More frequently, you may, with senior management's consent, impose extra requirements, such as hiring a construction manager or general contractor whose credentials satisfy the lender, thereby lowering the risk associated with the development

In either scenario, there is a strong likelihood of a lawsuit because your lending institution and the borrower made a legal agreement. You might need to consider what would happen if the borrower and engineer can't come to an amicable working arrangement after the loan closes.

 If you have the flexibility and power, you can veto the engineering firm and approve funding for the project without the complete support of your engineer. This is a difficult course of action that needs serious consideration. 

You can be making things worse by providing funding for a job that is already in peril. If you decide to cease funding because your construction loan may have been partially advanced outside the agreed-upon loan documents, you might be subject to legal liability. 

This establishes a precedent that the borrower may cite to support his case. On the plus side, depending on the specifics of a situation, when your inspecting engineer cannot cooperate or communicate with your borrower, you or the borrower can correct the underlying problem, neutralizing a potentially dangerous situation, by working directly with the borrower to keep the job moving.

The architect for the borrower and your consulting engineer

The development team of the borrower is the most crucial element in achieving a good project outcome. The architect has a lot of influence during construction, especially at the beginning. He is possibly the most critical team member at first.

Typically, the architect completes 80 per cent or more of their work before the above-ground construction starts. Since the designs and requirements are still being finalized, the consulting engineer will typically ask for more information than the architect can deliver. 

Working with a realistic assumption will be possible for an experienced architect and consultant. Getting started and paying for construction expenditures without finalized designs shouldn't be challenging.

However, an untrained or unprepared architect can struggle to match your engineer's requirements. Additionally, a novice or rigid examining engineer will have high expectations for the architect.

Given that you hired him in the first place, you should immediately go with your consultant if there is a conflict between the two. The only person who is formally on your side is him. Tell the borrower that he has to encourage his architect to give the engineer as much needed materials as possible.

Almost always, the engineer's request is not particularly unusual. However, the relationship is one-sided because the architect puts in the initial effort to deliver while the engineer only asks and reviews.

The architect's reluctance to request is frequently due to the time and labour required to fulfil them. However, this can indicate that the architect is not entirely aware of regional standards, is overburdened with work, or is searching for his next position. As a result, the developer may suffer, as well as you.

Step 4 - Planning and coordination of the project

Coordination is one of the words a construction manager uses the most. Organising all project duties by trade, including the delivery and installation of materials in a specified order and at a specific time, is known as coordination.

Many development teams build a table and a chart depicting the construction process from start to finish using some of the specialized and affordable computer applications available to help coordinate and track operations.

Planning and coordination of the project

The bar chart

The most common chart is a bar chart with dates, usually months, along the top row and tasks in the left-hand column.

To the right of each task, lines (bars) are drawn from the day the task will start up until the date when the task will be finished.

Various modifications will be made as the job advances on a regular basis (weekly or monthly), reflecting the interdependency of each task with the others. A delay in one activity might generate a domino effect that affects many other tasks; thus, there needs to be a realistic and well-thought-out sequence of planned occurrences. 

There should, whenever possible, be some overlap between trades, allowing another to begin working as soon as one completes a piece of the task. The chart is highly helpful in establishing the project's critical path because it follows the trade sequence. 

Some programmers update the graphic on a regular basis, adding new lines to represent updated completion predictions for each task. You should request a copy of the chart from the borrower or your consulting engineer. 

You may periodically check it throughout the construction process to see how far along the process work is compared to the initial chart. Be careful that the original chart will never accurately reflect the project's reality and may, in certain situations, exhibit a wide disparity.

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Step 5 - Get the environmental report

A Phase I environmental report must be ordered from a third-party environmental inspection company concurrently with the consulting engineer's examination of the property, cost estimates, permits, contracts, plans specifications, and other things.

Before issuing a construction loan commitment, an environmental survey must be finished. If this is not practicable, it should be made explicit in the construction loan agreement that it is conditional on a favorable environmental assessment of the property for any known, unknown, and potential concerns. 

Perform the environmental survey as soon as you can for the following reasons:

  • The most obvious justification is to determine as soon as possible if there are any significant issues that either you or the developer were unaware of.
  • Finding out the prospective expenses of removal or cleanup and major renovation, should the investment property require it, is a second justification. Determining the cost is typically a straightforward process if there is a problem. Since common environmental issues are found on properties virtually every day, the industry is flooded with qualified and seasoned competitors. It may just be necessary to include a budget line item for the removal of some asbestos or an underground oil tank. However, identifying risks necessitating a significant cleanup could render a project infeasible in other circumstances.
  • The time it will take to address environmental contamination is a third justification. Most financial institutions won't want to support the project if there is a severe environmental issue until the issue has been properly resolved. 
  • The fourth reason is to give you, your consulting engineer, and your environmental consultant enough time to study the proposed removal or remediation approach and incorporate it into the project's budget, schedule, and timeline.

Bottom line

Although getting ready for the construction loan funding process first appears complicated, perplexing, dependent on numerous third parties, and rife with possible difficulties, it is a regular process that happens with every development loan. 

Trusting others, to some extent, is the rule. No one can be thoroughly knowledgeable about the procedure, and even if there were such a person, it would be difficult for him to complete all the tasks simultaneously and promptly.

Because of this, the lender collaborates with many extremely skilled, knowledgeable, and certified individuals. Maintaining your composure at all times is a crucial requirement. Keep your attention on the task, heed counsel, and exercise good judgement.

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FAQs

How does construction home loan work?

A construction home loan is a type of mortgage that allows a borrower to finance the cost of building a home. The loan is disbursed in various stages as the construction progresses, and it's typically repaid once the home is complete.
There are two main types of construction loans: one that's based on the value of the property, and one that's based on the estimated cost of construction. The first type is a standard mortgage, while the second type is considered a riskier loan because there's no guarantee that the final cost of construction will be within budget.
Construction loans can be used to build either a new home or renovate an existing one. They're also available for both single-family homes and multi-unit apartments.

What are progress payments in construction loans?

A progress payment is a payment made to a contractor as work progresses on a construction project. The payments are usually based on milestones, such as the completion of a certain percentage of the work or the installation of a certain number of fixtures.
The payments help ensure that the contractor has the funds necessary to continue work on the project, and they also provide some assurance to the lender that the money being loaned for the project will be repaid. In order to receive progress payments, contractors are typically required to submit detailed invoices documenting their work.

What does a mortgage broker do?

A mortgage broker is someone who helps you find a loan to buy a house. They work with banks and other lenders to find the best deal for you. They usually charge a fee for their services.
When you go to a mortgage broker, they will ask you some questions about your full financial situation and your housing needs. They will then search through their database of lenders to find the best deal for you. They will work with you from the application process to closing.
If you're looking for home loans, it's always a good idea to talk to a mortgage broker first. They can help you get the best deal possible on a building loan.

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