Are There Any Risks Associated with Permanent Financing Vs. Construction Financing?

Getting around in the world of financiers can be challenging, especially when purchasing or constructing commercial property. There are two major types of loans: loans for permanent purchases and loans for construction projects. There are risks with all of them, but they are all essential. You can make intelligent decisions that will help you get the best funds for your project if you are aware of these problems. 

This is where CommercialConstructionLoans.net comes in. We can help you understand permanent financing vs. construction financing so you can choose the best one for your needs and level of comfort with risk. You can find out more about commercial financing here.

Permanent Financing vs. Construction Financing

Feature	Permanent Financing	Construction Financing
Loan Term	15-30 years	1-3 years (until construction is complete)
Interest Rate	Typically lower	Typically higher due to shorter term and higher risk
Disbursement Process	Loan is funded in a lump sum or installments based on project milestones	Loan is disbursed in draws based on construction progress

Permanent Financing

Permanent financing is the best way to pay for the costs of a finished commercial property in the long term. Construction loans pay for the construction phase. Permanent financing, however, starts once the project is finished and ready for renters or your business.

It’s like a loan for your commercial property. Permanent funding gives you several choices, such as:

• Banks and credit unions often give out commercial mortgages as a form of long-term borrowing. They usually need a significant down payment and have interest rates that are either set or can change.
• The SBA has loan plans for buying commercial property. These loans usually have lower down payment needs and reasonable interest rates. Still, they have tighter requirements for who can get them.

Repayment Process

Permanent loans are usually paid back over a long time, between 15 and 30 years. The loan is amortized, meaning the amount you pay each month includes the principal (the loan amount) and the interest. To show this, here’s a simple calculation:

Monthly Payment = (Loan Amount x Interest Rate x Term) / (1 – (1 + Interest Rate)^(-Term))

For example, let’s say you take out a permanent loan of $1 million at a 5% interest rate for a 25-year term (300 months).

In the example you mentioned, we can plug in the values

• Loan Amount (P) = $1,000,000
• Interest Rate (I) = 5% per year (convert to monthly for the formula: I = 5% / 12 months/year = 0.4167% per month)
• Term (T) = 25 years (convert to months: T = 25 years * 12 months/year = 300 months)

Using the formula

Monthly Payment = ($1,000,000 x 0.004167 x 300) / (1 – (1 + 0.004167)^(-300))

Your monthly payment would be approximately $6,202.

Construction Financing

For commercial construction projects, construction financing is a short-term way to get the money needed to buy land and finish the project. Permanent financing is used after construction, while construction financing gives you the cash you need during construction.

It’s like a credit line for the construction project. Some common types of construction loans are:

Loans for hard money: These are loans from private lenders with high interest rates and short terms. They are great for getting money quickly, but it takes longer to get approved and costs more.

Lines of credit for construction: A construction line of credit works like a credit card. It lets you borrow money as needed during the job, up to a limit you have already agreed to. Most of the time, interest is only charged on the amount used.

The draw-based method of payment

The way that construction financing is paid out is unique. With funding permanent, you get a lump sum payment all at once. With construction loans, the money is released in steps called draws. This ensures the money is used for what it was meant for and lowers the lender’s risk. 

How Construction Financing works

Project Costs and Schedule: A detailed construction budget and a timeline with important dates are decided upon. This will be used as a guide for making the draw plan.

Draw Request: When a certain point is reached, like when the foundation or framing is finished, the borrower sends a draw request for the loan. This request usually comes with proof that the work was done.

Approval and Inspection: The lender sends an inspector to check the work and ensure it fits within the price and time frame. Once the loan is approved, the provider sends the next installment.

Repeat it: This process of requests for draws, inspections, and payments continues until the construction project is finished.

Risks Associated with Permanent Financing

Permanent financing gives you the security of long-term funding for your commercial property, but it comes with some problems. Here are some critical risks to think about:

• Loan Qualification: The process of getting stable financing can be complicated. Lenders will look closely at your finances, including your credit score, the amount of debt you have compared to your pay, and how much money you expect to make and spend on the property. It may be easier to get a loan if you have good credit or a property worth more than it is worth.

• Real-life Example: The subprime mortgage disaster of 2008 showed how dangerous it is to have loose lending standards. Many people took out loans they couldn’t pay back, which caused defaults and a chain reaction in the banking system.

• Interest Rate Fluctuations: Interest rates on permanent loans are usually either set or can change. Fixed rates give you peace of mind but can be harmful if interest rates drop significantly after you lock in your loan. With an adjustable-rate mortgage (ARM), you may get a cheaper rate initially, but you could pay more monthly if rates increase.

• Real-life Example: The US had a time of high inflation and interest rates in the early 1980s. Many people who had ARMs saw their monthly payments go up, which caused a lot of people to stop paying and homes to be foreclosed on.

• Vacancy Rates: Getting and keeping lasting financing depends on how much your property makes. High vacancy rates, which mean that a large part of your construction still needs to be rented out, can lower your rental income and make it hard to pay back your loans.

• Real-life Example: The COVID-19 pandemic increased office vacancy rates as businesses shifted to remote work models. This impacted the cash flow of many commercial property owners and strained their ability to repay loans.

• Property Value Decline: Over time, the value of your commercial property may change. If the market drops, your home’s value could decrease, meaning you owe more on your loan than the property is worth.

• Unexpected Expenses: Hidden costs come with owning a property beyond your mortgage payment. Major repairs, upgrades, or environmental problems can strain your finances and make it hard to meet your loan responsibilities.

Key Risks of Permanent Financing

• Having trouble getting a loan
• Changes in interest rates
• A lot of empty rooms
• Property values going down
• Out-of-the-blue costs

Risks Associated with Construction Financing

Construction financing has a higher risk than permanent financing due to the constantly changing nature of construction. Consider these critical problems:

• Cost Overruns: Construction projects rarely go as planned, and costs can quickly exceed budget when things go wrong. These could be because of rising materials costs, a need for more workers, or unplanned changes at the construction site.

• Real-life Example: The new Raiders NFL stadium in Las Vegas cost over $500 million more to construct in 2017 than planned because of design changes and worker problems. This put a lot of stress on the project’s finances and the team’s relationships with government leaders.

• Project Delays: Construction delays can make your finances worse all around. These delays can happen because of bad weather, problems with permits, problems with subcontractors, or delays in getting materials to the project site. Delays make the loan term longer and add to the interest, and they can also make it harder to get stable financing or keep your lease agreement with tenants.

• Real-life Example: Due to problems in the supply chain and a lack of workers, the COVID-19 pandemic led many construction projects to be delayed. This had an effect on projects all over the world and made developers change their plans and funds.

• Unexpected Changes: During the construction process, problems can arise that were not expected. Finding dangerous materials, having issues with the structure, or following fresh construction codes can mean that the plan needs to be changed or more work needs to be done. These sudden changes can cause costs to go up and projects to be delayed, affecting your budget and loan terms.

• Contractor Risk: Choosing the right contractor is very important for the job to go well. Contractors who aren’t reliable or have a lot of experience may not do a good job, miss deadlines, or even go bankrupt in the middle of a project, leaving you trying to find a replacement and possibly losing money.

• Not Being Able to Get Construction Financing: To get construction financing, you must finish your job on time and at the right price. Let’s say your construction job takes longer than planned, or costs increase. That could make it hard to get stable money to repay the construction loan. You might have to sell the house for less than it’s worth or run out of money.

Key Risks of Construction Financing

• Cost overruns
• Project delays
• Unexpected changes
• Contractor risk
• Inability to secure permanent financing

Mitigating Risks Associated with Permanent and Construction Financing

To protect your investment and make intelligent decisions, you need to know about the risks that come with both permanent and construction loans. For lessening these risks, try these ideas:

Permanent Financing

Strengthen Your Financial Profile: Focus on creating a solid financial past, lowering your debt, and improving your credit score before you look for permanent financing. This will make you a better customer so that you can get a better loan deal.

Accurate Property Valuation: Make sure the property is valued relatively to avoid a loan-to-value ratio limiting your ability to borrow money or put you underwater if the market goes down.

Manage Vacancy Rates: Make a good lease plan to keep vacancies to a minimum. This could mean targeting desirable groups, setting reasonable rents, and providing excellent services for tenants.

Build a Cash Reserve: Keep a good amount of cash on hand to cover unplanned costs, like tenant repairs or changes. This extra money will help you repay your loans even if something unexpected happens.

Construction Financing

Thorough Project Planning: Make a detailed construction plan that includes the schedule, budget, and tasks needed. This plan should have backup plans in case of delays or cost overruns.

Accurate Budget Forecasting: Get help from professionals who know what they’re doing to make a realistic budget, considering material costs, labor costs, permits, and unplanned events.

Secure Experienced Contractors: Carefully check out possible contractors. Make sure you look at their credentials, references, and security. A strong provider with a good work history can lower the risk of delays and bad work.

Regular Monitoring & Communication: Talk to your worker regularly and closely monitor their work. Early detection and resolution of possible issues will help keep them from growing into more significant problems.

How CommercialConstructionLoans.net Can Help

CommercialConstructionLoans.net can help you figure out both permanent and construction loans, which can be hard to understand. They can help you by:

• Document Preparation: Ensuring your loan application is complete and looks good will increase your chances of getting the loan.
• Credit Score Improvement: Advising on improving your credit score and getting better loan terms.
• Lender Matchmaking: Put you in touch with lenders specializing in your project type and the amount of money you need.

By using these strategies to lower your risk and taking advantage of CommercialConstructionLoans.net’s knowledge, you can significantly improve your chances of getting the money you need to reach your business real estate goals.

How to choose between permanent financing and construction financing

You may select between permanent financing and construction financing at different development stages. Here is a list of the things you should think about:

Project Timeline

• Permanent Financing: Perfect for construction projects that are already finished but need long-term funds to buy or refinance.
• Construction Financing: Designed for projects that are still being planned, this financing helps bridge the gap between buying land and finishing construction.

Financial Situation

• Permanent Financing: To get good loan terms, you must have a solid financial background, a good credit score, and enough cash.
• Construction Financing: It may be more accessible for people with a limited story to get this type of loan, but the interest rates are usually higher, and the terms are tighter.

Risk Tolerance

• Permanent Financing: Offering stability with a set monthly payment (for loans with a fixed rate).
• Construction Financing: It has a higher level of risk because of the chance of cost overruns, delays, and problems that should have been planned for.

Decision-Making Framework

Here’s a simple framework to guide your decision:

1. Project Stage: Is your building already constructed, or are you still in the planning stages?
2. Financial Strength: Do you have a good credit background and a lot of cash?
3. Risk Tolerance: Are you okay with construction financing leading to delays and cost overruns?

Choosing the Right Option

Factor	Permanent Financing	Construction Financing
Project Stage	Completed Building	Development Phase
Financial Requirements	Strong Credit, Cash Reserves	More Flexible
Risk Tolerance	Lower Risk	Higher Risk
Loan Term	Long-Term (15-30 years)	Short-Term (1-3 years)

By carefully considering these things and using the decision-making framework, you can pick the best financing choice that fits your project’s schedule, budget, and level of risk tolerance the best.

Getting the Right Loan for Your Commercial Real Estate Project

Permanent and construction financing offer various options in your business real estate journey. Permanent financing gives finished buildings long-term security, while construction financing fills in the gaps while they are being built. There are risks with both choices, such as problems getting a loan for permanent funding cost overruns, and delays with construction financing.

Picking the right way to finance your project is crucial to its success. You can choose to meet your needs if you know about important things like the project’s timeline, your finances, and how much risk you are willing to take.

CommercialConstructionLoans.net can help you figure out how to get money for commercial property. Their team of pros can help you through the process and ensure you get the cash you need to reach your goals. Feel free to set up a meeting to talk about your idea in more depth. You can take charge of your future business real estate with the right financing.

FAQs

What is permanent financing?

Permanent financing is a long-term loan used to pay for the costs of commercial construction that has already been built. It’s like a mortgage for your commercial construction, and with fixed-rate loans, you can be sure of stable monthly payments.

What is Construction financing?

Construction financing is a short-term loan that helps you get the land you need and finish the construction of your home. It provides the money that is required during the development process. The money is usually given out in stages based on project milestones.

Which type of payment is best for me?

The best choice depends on where your project is. Permanent financing is best for construction already up and running, while construction financing is best for planned projects. Your cash situation and willingness to take risks are other things to consider.

What are the chances of getting permanent financing?

Some of the most significant risks are getting a loan, changes in interest rates, high turnover rates, property value drops, and costs coming out of the blue.

What are the risks of getting funding for construction?

Some important things to consider are cost overruns, project delays, changes that weren’t planned for, contractor risk, and the inability to get permanent funding.

Ask yourself, “How can I lessen these risks?”

Build a solid financial image, ensure the property is correctly valued, keep an eye on the number of vacant units, and save money for long-term financing. Planning the job carefully, making a budget, hiring experienced contractors, and regularly monitoring it are essential for construction financing.

What can CommercialConstructionLoans.net do for you?

They can help you prepare documents, improve your credit score, find lenders, and walk you through the funding process.

Are you ready to move on?

You can get their free checklist to learn more about your financing choices or meet with their experts to discuss your project.