How Construction Permanent Financing Works: Things you Need to Know

Abstract

Permanent Financing is one of the ways Developers can lower construction financing costs (Permanent Financing is also called as construction-to-permanent loan structuring and revolving lines of credit). One financing tool a Developer should have in their kits is the combined construction/permanent loan, which allows the Developer to partner with home buyers and benefits both parties.

The combination construction/permanent loan, which is also known as a “one-time close, a “single close,” or an “all-in-one” loan, is made to the home buyer instead of the developer. This permanent financing technique has long been used for higher-end custom homes where the home buyer already owns the lot, but now is being used in small and mid-size track developments as well.

In these cases, the construction phase of the loan finances acquiring the finished lot and constructing the home. This permanent financing technique can be used by Nigerian Banks by partnering with serious Developers in meeting the housing gap in Nigeria.

Introduction

Construction/permanent financing (loans) offer several advantages to Developer and home buyers. These loans save both the developer and the buyer time and money because the single loan closing eliminates multiple loan applications, approvals, fees and closing costs. Because the home buyer takes out the construction loan, the buyer pays the closing costs and interest instead of the developer.

In construction/ permanent financing, home buyers benefit from being able to lock in the rate on the permanent mortgage when construction starts, and they are generally allowed to shift to lower rates, if available, prior to completion of the home.

Moreover, since they are paying both the closing costs and the interest, these loans offer buyers some valuable bargaining points for obtaining a lower sales price.

Another benefit to home buyers is the ability to deduct the interest on the loan during the construction phase

For home Developer, other advantages include guaranteed sales contracts and avoiding lenders’ loans-to-one borrower limits. Indeed, this permanent financing arrangement stays off the developer’s balance sheet and keeps the developer’s lines of credit available for other projects.

Home Developer who has experience with construction/permanent loans find that because their customers are the borrowers in these transactions, the customers are more committed to the home purchase than home buyers who use more traditional purchase loans.

Further, the assurance of the permanent finance mortgage helps to overcome some lenders’ reluctance to make small residential construction loans that carry substantial overhead costs. Additionally, since bank/thrift regulators view the loan as a consumer mortgage loan, the maximum loan-to-value ratio during the construction phase is governed by regulations on permanent mortgages rather than the more stringent rules for developer construction loans.

From the developer’s perspective, a downside to these loans is that participating Developer are subject to lenders’ performance reviews. Some programs may also give buyers more control during construction than standard pre-sale contracts. Nevertheless, since these loans can offer substantial time and cost savings, Developer should ask their construction lenders about construction/permanent loan options.

How Construction-Permanent Financing Works

In permanent financing, the loan starts out as a construction loan (or acquisition/construction loan) and then rolls over into a permanent mortgage when the house is completed. Terms of construction/permanent loans vary, but generally, during the construction phase home buyers pay interest as a spread over prime, and the construction loan runs anywhere from 6 to 12 months.

During construction, the home developer receives periodic payment or “draws” from the lender. These draws usually require an inspection by the lender or lender’s representative and follow a schedule that is outlined when the loan closes.

When construction is complete, the outstanding amount of the loan converts to a permanent mortgage, either fixed- or adjustable-rate, with a term of up to 20 years. The rate and other terms of the permanent mortgage are set up-front when the entire loan package is closed. Loan amounts range from N10,000,000 to more than N60,000,000, with downpayment requirements established by each lender. Combined construction/permanent loans can be offered by several types of lenders, including banks, thrifts and mortgage companies.

Revolving Line of Credit Construction Loan in Permanent Financing

In permanent financing, a revolving line of credit construction loan (also referred to as a revolving loan) can minimize how often the developer incurs negotiable and non-negotiable loan fees and thus reduce a developer’s total financing cost. A line of credit provides the developer with permanent financing for several homes at a time, so the developer doesn’t have to take out individual construction loans for each home built.

The line of credit may specify the maximum dollar amount of the construction loans, the total number of loans, the duration of specific loans and the number of speculative homes and models that can be built under the line.

Lenders often prefer to provide a line of credit for pre-sold homes rather than for speculative building. The interest rate on revolving loans is usually tied to prime, but the margin is typically lower than that on individual loans because of the larger loan size of revolving loans.

Additionally, a revolving line of credit offers developer significant cost savings because there are fewer transactions and other recurring costs associated with several individual loans. When a developer obtains an individual construction loan for each home constructed, all of the associated costs are applied to each loan.

Thus, a developer who constructs 10 homes a year and takes out an N100 million construction loan for each home will borrow N1 billion over the year but will pay the same inspection costs, document preparation charges, recording fees, title insurance premiums, etc., on each loan. Instead, if the developer constructs the same number of homes under an N1 billion revolving loan, their marginal costs will be reduced due to fewer transactions costs, such as recording fees, incremental title insurance premiums, etc.

Some costs such as inspection fees may not be avoided or reduced by using a revolving loan, but others may be saved on an aggregate basis. The developer can realize even more significant cost savings by using the revolving nature of the loan to borrow more than its face value. This essentially reduces the loan fees because they are spread over a greater number of homes

A key advantage of revolving loans is the assurance of financing, which allows the developer to better schedule construction workflow.

Also, in permanent financing, the developer has the ability to “turn” the loan — to draw, build, sell, pay down, and draw again. Revolving loan structure in Nigeria for construction does have some complexities related to title insurance, documentary excise taxes, intangible taxes and other considerations specific to the lender’s and developer’s local jurisdiction.

Typically, lenders offering revolving permanent financing for construction will work out administrative methods for dealing with these issues. Revolving loans can offer significant savings for developers who are able to build, sell and close efficiently, and Developer should consult their lender about the possibility of using them.

Construction Financing in Nigeria

One of the major hurdles that almost any developer faces in a construction project is financing the construction and other development costs. More and more, developers are finding themselves involved in the financing process. Indeed, a complete lack of involvement is almost impossible to avoid on today’s projects.

Lenders, endeavouring to reduce financing risks, will look directly to the contractor for various assurances, certifications, and agreements regarding the construction of the project and its completion. Developers, seeking new business opportunities or higher profits, will on occasion participate directly in the financing or development of a project.

A construction loan is simply a loan made on the security of a real estate mortgage (and perhaps other collateral), the proceeds of which are disbursed periodically (usually monthly) to pay the hard and soft costs of construction.

They can be among the most complex real estate loans (compared to land acquisition loans or permanent loans, for example), and intimately involve the activities of the construction contractor. Understanding construction financing can help a developer provide additional value to its clients and enhance its competitive position.

Involvement in the financing process, however, is fraught with risks, which a developer must understand if it is to protect its profitability. Usually, two major loans are required to finance a project, although some lenders will combine these into one. The two loans types are:

• (1) Short-term financing to finance the construction stage.
• (2) Long-term, permanent financing of a mortgage loan obtained upon completion and stabilization, used to finance the project over its normal operating life. Stabilization is the point at which a project has fully leased up to the market level of occupancy and has been in operation long enough to have a solid track record of income and expenses on which a lender can rely in making a permanent, long-term loan.

Short-term financing / Construction financing in Nigeria

Occasionally a developer may obtain some sort of preconstruction short-term financing such as land purchase loans, land development loans, “front” capital, or “gap” financing; however, these types of loans are relatively rare and expensive for the simple reason that there is inadequate collateral to secure the loan.

Although the land itself can serve as collateral, loans on raw land are typically at 50% or less of market value because raw land is illiquid (it cannot be readily converted into cash), and raw land does not produce an income stream with which to service the loan. Lending funds to cover development costs prior to the start of construction is highly speculative, and the rates charged on such a loan, if it could be obtained at all, would reflect those risks.

The construction loan is usually the first institutional-quality loan involved in a development project. Construction loans are most commonly made by commercial banks; however, many other institutions are players in the construction loan arena, including life insurance companies and various finance companies.

Also, construction loans are meant to be replaced with permanent financing when the project is completed. Obviously, the construction lender is in an undesirable position if the developer is unable to obtain permanent financing at the end of construction. The degree of assurance that the construction lender requires so that permanent financing will be available at the end of construction varies according to the type of project.

In permanent financing, in one end of the spectrum, a construction lender may require a take-out commitment (a promise of permanent financing) from a lending source that it considers credible before it is willing to lend on certain types of office or retail developments that have not presigned any major tenants. On the other hand, a construction loan for a well-sited apartment community by an experienced developer and investor team would not typically require any commitment from a permanent lending source.

Permanent Financing

There are several sources from which a developer can obtain permanent financing for a project. The source to approach depends on the size and nature of the project. In some instances, a particular lending institution can handle any type and size of the real estate venture. But there are some financial institutions, such as insurance companies and pension funds, which will not lend less than a million naira.

On the other hand, all banks are restricted to lending no more than 5% of their equity capital on any one loan, and for certain smaller or regional commercial banks this may mean they cannot lend on larger projects. However, even when a small bank is incapable of handling a larger loan, as in the case of permanent financing, it can join forces temporarily with another bank or banks, all participating in a given loan, thus forming a financing joint venture.

In that case, the originating bank handles the details involved in getting the total sum requested by the developer. The developer usually has no contact at all with the other participating banks, because all of the joint loan agreements with the other banks are worked out by the originating banks. Moreover, the process of lining up the other participating institutions may delay processing the loan, particularly if there is anything unusual about the project, loan application, or borrower.

The term permanent financing is a bit of a misnomer because much so-called permanent financing, although amortized over 15 or 20 years, is for a term of just 10 years.

Remember, amortization refers to the length of time it will take for a given periodic payment of principal and interest to extinguish debt, whereas the term refers to the length of time the debt is being owed. When the period of a term is shorter than the period of amortization, then the debt is said to balloon, and a single large payment of principal is due to repaying the loan at the end of the term.

Permanent, fixed-rate financing frequently has prepayments penalties. Prepayment penalties range from a basic yield maintenance formula designed to maintain the lenders’ expected to return in case a borrower decides to refinance because of falling interest rates, to high set fees that seem to be structured more as profit centres for the lenders than to address any true cost involved or compensate for lost profits.

Conclusion

Note that, in presenting your project to Lenders an Information Memorandum must be developed. Always remember that an Information Memorandum is a selling document.  Be factual and concise, but also make certain that you’re putting the asset forward to your Lenders in a compelling way.  Banks have got a lot of investment and lending opportunities to consider – you want yours to stand out from the crowd.

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