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New Home Construction Financing — Rule # 1 — Have ALL The Money You Need BEFORE Building!

Posted March 2nd, 2009 in Mortgage Loan Insights

You might think that it only makes sense to begin constructing a new home AFTER all financing is in place and sufficient to complete the project, but I’m receiving loan inquiries from property owners who have begun construction and are at varying levels of completion but are short the funds needed to complete the project.

It’s one thing to incidentally run short of money once you begin building due to unforeseen cost overruns, but you’re asking for trouble if you intentionally begin construction without approved financing and at least another 10% cash contingency reserve in place before you begin. If you’re inclined to think you can start construction now and somehow find additional funds to complete the project later you’d be advised to postpone building altogether until you have the capital available to see it through.

Traditional banks won’t finance construction that’s already begun due to “broken priority” title issues, and that leaves you with only hard money as a possible option.

Let’s look at a few critical issues a hard money lender will have when making a construction-completion loan:

“Loan-to-Cost” Basis versus Loan-to-Completed Value

You’ll need a very substantial amount of existing equity in the property, since a hard money loan will cover the lesser of a percentage of Loan-to-Cost (“LTC”) or Loan-to-Finished Value (“LTV”). In nearly all cases this is Loan-to-Cost. If you calculate 65% of the total remaining cost to build that would be the maximum amount of any new loan before payoff or consideration of existing liens (if applicable), contingency reserve, and points and loan fees. If the net amount is insufficient to complete the project you’ll need additional cash to close the transaction.

Documented Cash Vested In The Project

You’ll need to show a hard money lender that you have at least 30% of the total cost to complete construction already vested in cash in the project, or escrow the difference you need to complete it. Your cash contribution can be down payment paid on the lot, soft costs, interest paid on existing notes, or cash purchases of materials and/or labor not financed. Cash vested in the project is NOT the same as equity in the land. The current fair market value of the lot is a consideration to a hard money lender, but only as a portion of the proposed completed value may be concerned and not a basis for your “equity” in the project. “Equity” to a private construction lender is CASH invested in the project.

Be Prepared To Document Income And Have A Viable Exit Strategy

“Stated Income” construction loans are no longer available from banks, and have become rare even for hard money lenders willing to loan on an incomplete construction project. A privately funded construction loan is typically due in full within 90 days from completion of the project. You can expect to show the hard money lender that you have the ability to make payments on his loan (assuming an interest reserve fund is limited or not in effect) through the course of construction and beyond. Without it, or at the very least a very viable exit strategy for selling or refinancing the property at completion there’s little incentive for the lender to make you a loan–he’d rather not make the loan to begin with than deal with foreclosing on it later no matter what it’s completed value may be.

Forget “Owner Builder” Hard Money Loans

Unless you’re a licensed general contractor don’t expect a hard money lender to finance your project, even if you’ve “done it before”. The lender expects certain standards to be met for quality, efficiency, know-how, and liability that only an industry professional can provide. There are general contractors everywhere who, for a fee, will supervise your project and still allow you to act as a subcontractor or use licensed subs yourself.

Draw Disbursements, NOT Vouchers

You can expect a hard money construction lender to disburse funds as work is completed, just as any bank would. Funds advanced of the work being performed or for the purchase of materials isn’t acceptable, so make sure your contractor is sufficiently capitalized to carry the cost of material and labor in advance of being reimbursed on an agreed-to draw schedule.

Don’t Expect Bank Terms For Hard Money Loans

Hard money loans do NOT compare in any way to bank terms insofar as interest rates, points, and some other factors like loan-to-cost ratios are concerned. The typical hard money construction-completion loan carries a rate of between 11.50% and 15.00% and 6 to 10 points, plus applicable 3rd party costs (escrow, inspection, title insurance, appraisal, etc). It is conservative in it’s approach. It is short-term, high-risk lending (no matter what you think the property will be worth when it’s completed), and carries additional considerations not applicable to other already-built investments available to a lender. So don’t expect a “good deal” if you’re seeking hard money — be glad that a lender is willing to make you a loan on an incomplete project and focus on the after-completed benefits to you instead. If interest rate and fees are your primary concern head to your nearest bank instead.

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Disclaimer: The advice and opinions expressed herein do not constitute legal advice and are intended for general informational purposes only based on the working experience of the author only. The author is not a licensed attorney. The opinions contained herein are made exclusively by the author and not those of Augusta Financial Inc, it's ownership, management, or other employees. No guarantees as to the validity or legal aspects of the information contained herein are made, express or implied. Accuracy of this information is subject to change per market conditions or the author's experience in the industry. No guarantees are expressed or implied as to the viability of real estate as an investment. Personal credit issues are subjective. Real estate, finance, investment, and landlord-tenant laws and regulations vary state-by-state. You should consult with a licensed real estate attorney in your area for all matters pertaining to the legal aspects of selling, purchasing, financing, investing in, or rental of real estate whenever legal and/or financial implications are (or should be) a consideration. Page copy protected against web site content infringement by Copyscape
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