Navigating New Construction Loans: Financing Your Business Build

You’re ready to launch your business—your plan is solid, your products and services are set, and your team is coming together but there’s one big question left: Where will you set up shop? Leasing an existing space is always an option, but if you’re thinking about building your own commercial space from the ground up, you’ll need new construction financing. This guide will help you navigate the ins and outs of new construction loans so you can bring your vision to life.

Financing Options for New Businesses

Building a structure from the ground up requires construction loans for most business owners. New construction loans are short-term loans that are used for the sole purpose of financing a new structure. These loans have different funding and repayment terms than traditional permanent mortgage loans.

It is important to understand the specific types of new construction loans, and their repayment terms, as well as all relevant disclosures, before deciding on what might be the best construction loan for your business.

What Can Construction Loans Be Used For?

Eligible expenses for construction loan funds depend on the type of loan, loan amount, and terms, so check with your loan officer on any use you may be unsure of.  Most new construction loans can be used for real estate, construction plans, drawings, and permits.

Construction loan funds can also be spent on labor and materials for the structure as well as purchasing equipment that will be used in the construction process. Some loans will also cover closing costs, interest reserves, landscaping, and insurance.

Check to see if your construction loan allows for funding a contingency reserve if the construction project ends up costing more than originally budgeted.

How Do Construction Loans Work?

Construction loans work differently than traditional mortgage loans. The funds borrowed in this type of loan are not disbursed upfront in one lump sum but in a series of payments made throughout the construction phase.

The release of funds is usually called a disbursement and often occurs at scheduled milestones throughout the project. Some lenders follow a fixed disbursement schedule based on the original budget, while others adjust draw amounts based on actual construction costs at each stage.

Often an inspection is required before each draw. The purpose of the inspection is to reassure the lender that the work progresses as reported.

What Are the Different Types of Construction Loans?

Construction-Only Loan

Construction-only loans are sometimes called construction mortgage loans, or “two-close” construction loans. They are short-term loans with terms matching the expected completion time of the project.

Typically, the lender finances part of the construction costs, while the borrower is responsible for covering the rest. You will be making interest-only payments throughout the life of the loan but be responsible for paying the balance at the completion date.

While options to refinance these loans are available, they can be limited.

Construction-to-Permanent Loan

This type of construction loan is common. Construction-to-permanent loans are also called CP loans or “single close” construction loans, offering a path to permanent financing.

They offer the most predictable interest rate because they are locked in at closing costs, unlike loans with an adjustable rate. This type of construction financing combines the construction loan with the mortgage loan, which saves money with only one set of closing costs.

Like construction-only loans, only interest payments are paid during the construction period. After occupancy is complete, the loan programs usually call for the borrower to pay interest rate and principal.

Commercial Construction Loan

The commercial construction loan is typically used for large projects like an entire office building, hotel, or apartment complex. These loans are offered within the real estate industry by select lenders and carry more risk than construction-only or construction-to-permanent loans.

Because of the risk involved, borrowers or home building business owners must cover most of the construction costs, especially when applying for one of the best owner builder construction loans.

For instance, if you're building a small boutique store, a construction-to-permanent loan might be ideal. On the other hand, if you're constructing a large apartment complex, a commercial construction loan would be more suitable.

New Business Construction Challenges

Securing a construction loan for a new business can be challenging. Because of the risks, borrowers are required to provide thorough documentation before getting preapproved for a construction loan.

Borrowers also face high down payment and high construction loan rates. In addition to standard mortgage documentation, construction loans often require multiple inspections and evaluations of architectural plans and construction schedules.

A lender may even ask that you provide some credit score history on the general contractor you wish to use.

Even after applying, new businesses may struggle to get approval due to strict lending criteria. If you are working with a lender to get a construction loan you may run into some red tape because of the following factors:

• No Credit History: Banks are often reluctant to lend to new businesses without an established credit history. In such cases, lenders may require the business owner’s personal credit score instead.
• Inconsistent Income and Cash Flow: As a new business owner, it is difficult to show any consistent revenue or cash flow because the business has not been operating long enough. While this lack of history will hold up traditional mortgage loans for a small or new business, it is even harder to get around these requirements with construction loans.
• Insufficient Debt-to-Income Ratio: Many lenders are not willing to work with new businesses that have taken out any other type of loan because of their debt-to-income ratio. New businesses often lack the income history to support one loan, let alone an additional loan. If you already have home loans with a bank or lender to fund the startup of your business, it may be near impossible to secure an additional construction loan.
• Nonexistent Organizational Charts: When applying for construction loans or any business bank loans, lenders will often want to analyze the org chart of the business. The org chart lists management and their role in the company. They use the chart to gauge the integrity of the business. For startups, something as small as a missing org chart may make getting a construction loan more difficult.

Successfully securing a construction loan for a new business demands careful preparation and a thorough understanding of the significant obstacles involved.

Economy and Industry Trends

You would not start a business in an industry that you believe to be declining. However, lenders have their own set of standards for industry predictions, and they may differ from yours.

You may not be able to get a construction loan if the lender deems your business’s industry as declining. Lenders that finance construction loans often take the economy into consideration as well. If the economy is considered unfavorable by financial institutions, getting a construction loan for a new home business may not be an option.

Explore Other Financing Options

When considering your options, you might start by searching for new construction loans near me to identify lenders specializing in this type of financing. Start by researching various new construction lenders beyond traditional banks and mortgage companies to get a sense of your options.

Depending on the eligibility requirements you may also be able to raise capital by revenue-based financing, equipment financing, a line of credit, or a commercial real estate loan if you happen to already have commercial real estate.

Some new business owners find that outside investors, personal loans, or even business credit cards may be helpful.

Small businesses often have success working with the loan programs offered by the Small Business Administration (SBA). FHA SBA loans, including the FHA SBA 7, often offer low-fixed rates and affordable monthly payment.

The U.S. Small Business Administration (SBA) offers resources that can help small business owners understand different financing options and what SBA loans can be used for as it relates to your construction.

Build Business Credibility Without Home Construction

Most business owners will likely find that they can establish operations in a rented space, building credibility and establishing cash flow along the way. This is also less risky than home construction loans because if your entrepreneurial idea turns out to be a bust, you won’t be on the line for the construction loan. So before stressing about whether or not you can get preapproved for a construction loan, consider making these efforts for your new business:

• Invest in Marketing: Marketing in its most basic form is getting the right message, to the right people, at the right time. When you first launch your startup, you need to build a brand and get your name in front of potential customers. This is true regardless of your industry.
• Focus on Customer Service: Loyal customers are the keys to success for any business. Since you only have one chance to launch a startup for the first time, make sure you are providing quality products and services that customers will rave about. This will establish you as a trusted company, even if you are still relatively unknown, and will help you get a leg up on the competition.
• Keep Good Records: If you know that you want to take out a construction loan in the near future, the best thing you can do to ensure the process goes smoothly is to keep good records and communicate

By prioritizing marketing, customer service, and diligent record-keeping, new businesses can build a solid foundation for future growth and potentially bypass the immediate complexities of securing a construction loan.

The Bottom Line

While building a commercial space for your business can be a compelling vision, securing a construction loan can present significant hurdles. Thorough preparation, exploring financing avenues, and even considering the less capital-intensive route of establishing operations in an existing space first can ultimately pave a more sustainable path to realizing your business goals.

FAQ for new construction loans

What are new construction loans?

New construction loans are short-term financing options that cover the costs of building a new structure. These loans typically disburse funds in stages as construction progresses. They differ from traditional mortgages, which finance completed properties.

How do I qualify for a new construction loan?

Lenders typically require a strong credit score, a detailed construction plan, and a significant down payment. You may also need to prove financial stability and provide cost estimates from licensed contractors. Some lenders may request personal credit history if your business is new.

What can new construction loans be used for?

They can cover land purchases, construction materials, labor, permits, and equipment. Some loans may also include funds for contingencies, closing costs, and interest reserves. Specific usage depends on the lender and loan type.

How do lenders disburse funds for new construction loans?

Unlike traditional mortgages, funds are released in stages based on construction milestones. Inspections may be required before each disbursement to ensure the project is progressing as planned. The borrower usually makes interest-only payments during construction.

What are the advantages of taking out a new construction loan?

New construction loans provide the flexibility to design a space tailored to your business needs. They also allow for staged funding, ensuring that payments align with construction progress rather than requiring a large upfront investment. Additionally, some loan options offer interest-only payments during construction, helping to manage cash flow until the project is complete.

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