Ground-up commercial construction is one of the most capital-intensive activities in real estate. Unlike acquiring a stabilized building, construction financing requires specialized loan structures, rigorous underwriting, and a different set of lender relationships. Here's a comprehensive guide to how it works.

What Is a Construction Loan?

A construction loan is a short-term financing facility that funds the building of a new commercial property. Unlike a permanent loan that's disbursed in full at closing, a construction loan is drawn down in stages as construction progresses. Key characteristics include:

  • Term: 12-36 months (aligned with construction timeline)
  • Rate: Floating, typically SOFR + 300-500 basis points
  • LTC: 55-75% of total project cost
  • Disbursement: Monthly draws based on completed work
  • Interest: Paid only on the amount drawn (not the full commitment)

The Construction Loan Process

Step 1: Pre-Development

Before approaching lenders, you need:

  • Entitled land or purchase contract: Zoning, permits, and environmental clearance
  • Architectural plans: Complete construction documents
  • General contractor: Licensed GC with a guaranteed maximum price (GMP) contract
  • Pro forma: Detailed budget and projected returns
  • Pre-leasing (for commercial): Many lenders want 30-50% pre-leased before funding

Step 2: Loan Application & Underwriting

Construction loan underwriting is more intensive than permanent financing. Lenders evaluate:

  • Sponsor experience: Your track record with similar projects
  • Project feasibility: Market demand, comparable rents, absorption timeline
  • Budget review: Line-by-line cost analysis, often verified by a third-party cost consultant
  • Contractor qualification: GC financial strength, bonding capacity, track record
  • Exit strategy: How you'll repay — permanent takeout, sale, or refinance

Step 3: Loan Closing

At closing, the lender establishes the loan facility but doesn't fund the full amount. You'll typically need to contribute your equity first (the "equity-in-first" requirement). The loan documents will include a detailed draw schedule, construction timeline, and milestone requirements.

Step 4: Draw Process

This is where construction loans differ most from other financing. Each month during construction:

  1. The GC submits a draw request detailing work completed
  2. The lender's inspector verifies the work on-site
  3. The lender approves and funds the draw (typically within 5-10 business days)
  4. You use the funds to pay the contractor and subs

Interest accrues only on the amount drawn, so your carrying cost increases as construction progresses. Most construction loans include an interest reserve — a budgeted amount within the loan to cover interest payments during construction.

Step 5: Completion & Takeout

Once construction is complete and you receive a certificate of occupancy (CO), you'll need to execute your exit strategy. For most projects, this means:

  • Lease-up period: Fill the building to stabilization (usually 6-12 months post-CO)
  • Permanent refinance: Replace the construction loan with long-term permanent financing
  • Sale: Sell the completed project to a long-term holder

Many construction loans include a "mini-perm" feature — an automatic conversion to a short-term permanent loan at maturity, giving you additional time to stabilize and arrange takeout financing.

Key Construction Loan Terms to Know

Loan-to-Cost (LTC): The percentage of total project cost the lender will finance. Typically 55-75% for commercial construction.

Loan-to-Value (LTV): The loan amount as a percentage of the projected completed value. Usually capped at 70-75%.

Interest Reserve: Money budgeted within the loan to make interest payments during construction, so you don't need to fund them out of pocket.

Retainage: A percentage (usually 5-10%) of each draw that's held back until construction is complete, ensuring the contractor finishes the job.

Completion Guarantee: A personal guarantee that the project will be completed on budget. Most construction lenders require this from the sponsor.

Tips for Getting the Best Construction Loan

  1. Build your track record: Lenders heavily weight sponsor experience. If you're a first-time developer, partner with an experienced developer or GC.
  2. Get pre-leasing: Nothing de-risks a project for a lender like signed leases. Even LOIs can help.
  3. Use a reputable GC: A well-known general contractor with bonding capacity makes lenders more comfortable.
  4. Budget conservatively: Include 5-10% hard cost contingency and 3-6% soft cost contingency.
  5. Plan your exit: Have the permanent takeout lined up, or at least identified, before you start construction.

At CLS CRE, we structure construction loans for projects ranging from $2 million to $100+ million across all property types. Our lender relationships span banks, credit unions, life companies, and private capital sources that actively seek construction lending opportunities.