By Drew Smith, Peoples Bank
Climbing rent prices, declining inventories, and low rates are creating an opportunity for business owners to consider the advantages of new construction. If your business has expansion plans and you’re outgrowing your current space, you have significant tenant improvements to make on your existing building, or you want a better location for your business, a lender can explain the ins and outs of new construction lending and help you achieve the long-term security associated with owning your own building.
When it comes to underwriting commercial loans, banks look at a multitude of factors, and construction financing is no different. Could new construction be the right move for your business? Here are some factors to keep in mind.
A trusted contractor mitigates lending risk. Borrowers often underestimate the importance lenders put on the reputation of the project team assembled. Due to the inherent risk associated with all construction projects, the more experienced the contractor is, the more comfortable the bank will be to take on the risk. Be prepared to explain how experienced the contractor is with the type of construction project you’re proposing, how speculative the project is, if signed leases are in place, and if the project principals have excess liquidity and outside income to support the project in the event of cost overruns or project delays.
Cash on hand can offset risk. If there are perceived weaknesses in a project, a lender will lean more heavily on other aspects of your loan application. This could include requiring more cash on hand to cover possible contingencies. In general, a lender will want to know how much cash the borrower has in the project, as well as the proposed loan amount compared to the value of the project (loan to value). The lender will also be interested in the loan repayment source. For example, is it an owner-occupied building for a successful business? Does the repayment come from the property itself (via lease income)? Who are the tenants, and how are the leases structured? A loan secured by a building with an investment grade tenant is viewed differently than a tenant who doesn’t provide the same financial strength and stability.
Fixed bids can help you stay on budget. A fixed bid contract is one where the contractor gives a contractual bid to complete the project for a pre-determined price. Assuming there are no change orders or allowance overages, the contractor is required to complete the job for the pre-determined dollar amount. If the project costs more money than expected (even if it costs more than the original bid), that burden is borne by the contractor. Banks tend to have a strong preference for fixed bid or ‘guaranteed maximum price’ contracts as they limit the risk associated with overall project costs.
Be aware of the costs involved. In addition to the price of the land and the construction costs themselves, business owners should have a firm understanding of other expenses related to construction financing. For example, interest reserves are the cost of loan interest while the building is under construction. Say, for example, you’re building an apartment building. During construction, the building is vacant and not generating income, but there is still a loan to service. It’s a carrying cost that is often overlooked when budgeting for a new project. Other costs include loan fees, third-party financing costs (title, escrow, construction draws), contingency reserves, permitting, and additional soft costs. It’s a good idea to discuss these costs with your lender and make sure you are budgeting for the project accordingly.
Whether your business needs new industrial warehouse space or you’re seeking a high-traffic downtown storefront, it’s an exciting time to take advantage of current market conditions in Island County while contributing to the economic vitality of the community. If new construction sounds intimidating or more than you’re ready for, remember that it’s never too early to start the conversation with a lender about your long-term plans, to see if new construction makes sense for you.
Drew Smith is a Senior Vice President and Commercial Banking Officer at the Peoples Bank Bellingham Commercial Banking Group. For more information, please contact a local lender at our Peoples Bank branches in Coupeville and Oak Harbor.