Construction Debt

Construction debt refers to a specific type of loan used to finance the building or significant renovation of a real estate property. Also known as a construction loan or a self-build loan, it typically covers the costs of land acquisition and construction.

The terms and conditions of construction loans can vary significantly, but they often have the following characteristics:

Short-term: Construction loans typically have a term of one year or until the construction is complete. Once the construction is finished, the loan is usually replaced or refinanced with a long-term mortgage.

Interest-only: During the construction phase, borrowers may only need to make interest payments on the amount drawn.

Drawdowns: Funds are drawn down at various stages of the construction process, not all at once. The borrower takes an initial draw to cover specific costs, and subsequent draws are made as needed throughout the project. This helps manage interest costs since interest accrues only on the amount drawn.

Monitoring: Lenders may require regular inspections to confirm the construction is progressing as planned before releasing additional funds.

High-interest rates: Construction loans are typically more expensive than traditional mortgages. They pose a higher risk to lenders, as the project could fail, the builder could default, or the property value could decrease.

Loan-to-Value (LTV) and Loan-to-Cost (LTC): These ratios are key considerations for lenders. They help assess the risk associated with the loan and the borrower's equity in the project.

Once construction is complete and the property begins generating income (in the case of an income-producing property like an apartment building or retail center) or is sold (in the case of a residential development), the borrower typically refinances the construction debt with a more traditional, long-term mortgage.