How Are Commercial Construction Loans Underwritten?

Construction lenders underwrite commercial construction loans using five ratios:  (1) the Loan-to-Cost Ratio; (2) the Loan-to-Value Ratio; (3) the Debt Service Coverage Ratio; (4) the Profit Ratio; and (5) the Net-Worth-to-Loan-Size Ratio. The process sounds complicated, but the math is actually very simple.


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Before we get into each of the five construction loan underwriting ratios in details, let's make sure we are applying to the right kind of lender.  Most commercial construction loans are made by a lender located close to the proposed project.  In real life, you will almost never see some big New York bank with lower rates come swooping in to steal a small commercial construction loan from some nearby bank.  Commercial construction loans are made by local lenders because the lender needs to conduct six or seven progress inspections over the term of the loan to make sure that the bank's dough is actually being used to construct the building.

Secondly, most commercial construction loans are made by commercial banks, as opposed to life companies, conduits, credit unions, REIT's, non-prime commercial lenders, or hard money commercial lenders.  The reason why is because banks are set up to easily disburse small loan amounts.  In contrast, life companies seldom want to bother with issuing loan checks of less than $5 million.   In addition, commercial banks greatly prefer short term loans.  Most commercial construction loans have a term of just 12 to 18 months, which is right in the sweet spot for a bank.  Finally, commercial construction loans can be very profitable to the bank.  The bank typically earns one or two points up-front, but the bank isn't required to disburse most of the loan proceeds until much later in the term of the loan, as construction is completed.  This supercharges the bank's return on investment.  As a result, most banks love to make commercial construction loans, as long as the economy is fairly healthy.


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But will your project qualify for a commercial construction loan?  The bank will use five major underwriting ratios to qualify your commercial construction loan:

  1. Loan-to-Cost Ratio
  2. Loan-to-Value Ratio
  3. Debt Service Coverage Ratio
  4. Profit Ratio
  5. Net-Worth-to-Loan-Size Ratio

We will examine each of these ratios in turn below.  Now, guys, below you will find ratios that appears to include - gasp - algebra.  Relax.  I assure you there is no algebra involved.   These calculations are simple 5th grade math - addition, subtraction, multiplication, and division - so please don't let your eyes glaze over.  This is important knowledge, and I'll do my best to make it fun.  Onward.

1.  Loan-to-Cost Ratio

The most important ratio in commercial construction loan underwriting is, by far, the Loan-To-Cost Ratio.  The Loan-to-Cost Ratio is the construction loan amount divided by the total cost of the project, the result being mutiplied by 100%.  

Loan-To-Cost Ratio = (Construction Loan Amount / Total Project Cost) x 100%

Loan-to-Cost Ratio's look like this:  86.1% LTC or 80.0% LTC or 76.4% LTC.  Obviously the lower the Loan-to-Cost Ratio, the safer the loan is for the bank.

The Total Cost of the Project is the sum of the land cost, the hard costs, the soft costs, and a contingency reserve equal to around 5% of hard and soft costs.  Usually a commercial bank will insist on a Loan-to-Cost Ratio of 80.0% or less.  In other words, the developer must have at least 20% of the total cost of the project invested in the deal.  Are you, a developer, short of equity.  Here is how to raise more equity.


Bubba Johnson is a good 'ole boy and a shady real estate developer.  He wants to build some apartments in Atlanta, so he applies to Nearby Southern Bank for a $2 million commercial construction loan.  Will he qualify?  Does he have enough of his own dough in the deal?  In other words, does he have enough skin in the game?

Bubba paid $250,000 for the land, but he didn't pay with all cash.  He only put down $75,000 in cash, and the seller carried back a $175,000 contract of sale (think of a contract of sale as just a first mortgage carried back by the seller).  About now some of you are probably thinking, "Hmmm, this may not be a do-able deal.  Most banks require the developer to contribute the land to the project free and clear (or at least pretty close)."

Continuing with our example.  Bubba gets bids and submits a hard cost breakdown of $1,300,000.  His projected soft costs, including construction period interest, are $410,000.  A contingency reserve of 5% of hard and soft costs would be $85,500.  We are now ready to compute the Total Project Cost.

Total Project Cost = Land Cost + Hard Costs + Soft Costs + Contingency Reserve

Total Project Cost = $250,000 + $1,300,000 + $410,000 + $85,500

Total Project Cost = $2,045,500

Now let's compute Bubba's Loan-to-Cost Ratio:

Loan-To-Cost Ratio = (Construction Loan Amount / Total Project Cost) x 100%

Loan-To-Cost Ratio = ($2,000,000 / $2,045,500) x 100%

Loan-To-Cost Ratio = 97.8%

Do you really think some bank is going to be foolish enough to cover 97.8% of the cost of some risky construction loan?  Of course not!  The general rule is this:  Banks typically want the developer to cover at least 20% of the total cost of a commercial construction project.  That's a pretty important sentence.  You might want to read it again.

Okay, so how much dough will Bubba need to contribute to get this apartment building constructed?  Answer:  At least twenty percent of the total project cost.  Okay, let's do the numbers.  We already know the Total Cost of the Project from above.

Minimum Developer's Contribution = Total Project Cost x 20%

Minimum Developer's Contribution = $2,045,500 x 20%

Minimum Developer's Contribution = $409,100

Now the only dough that slimy Bubba has in the deal so far is the $75,000 that he put down on the land.  He is short by $334,100; so Bubba puts on his manilla-colored, light-weight three-piece suit, inserts his bright yellow pocket hankerchief, and heads off to the home of his 92-year-old grandmother, Grammy Sara.  Promising her a rock-solid, "guaranteed" investment, he convinces Grammy Sara to mortgage her free-and-clear home and to give him the $334,100 he needs to cover 20% of the total cost of the project.

2.  Loan-to-Value Ratio 

The Loan-to-Value Ratio, as it pertains to underwriting a commercial construction loan, is defined as the Fully-Disbursed Construction Loan Amount divided by the Value of the Property When Completed, as determined by an independent appraiser selected by the bank, all times 100%.

Loan-to-Value Ratio = (Fully-Disbursed Construction Loan Amount / Value of the Property When Completed) x 100%

Generally banks want this loan-to-value ratio to be 75% or less on typical commercial-investment properties (rental properties like multifamily, office, retail, and industrial) and 70% or less on business properties, such as hotels, assisted living facilities, and self storage facilies.

Example Continued:

Proud as a peacock, shady Bubba sits down with his banker and shows him the $334,100 cashier's check from trusting, 'ole Grammy Sara.  "My Total Construction Cost were $2,045,500.  You said that if I could cover 20% of the total cost, you would make me a construction loan for the rest.  Well, I came up with the 20%.  When can you have the legal documents ready on my $1,636,400 construction loan?" asks Bubba.  "Not so fast there, Bubba," replies his banker.  "You have satisfied the Loan-to-Cost Ratio test, but now we also have to check the Loan-to-Value Ratio test."

A grumbling Bubba writes the bank a check for $4,000 - money he had planned to spend on Lola La Boom-Boom and some nose candy - to cover the cost of an appraisal and the toxic report.  Five weeks later (the appraiser was constantly making up excuses) the appraisal has finally been completed.  It came in at $2,100,000.  Will this be enough?  Well, lets do the calculations.

Loan-to-Value Ratio = (Construction Loan Amount / Appraised Value Upon Completion) x 100%

Loan-to-Value Ratio = ($1,636,400  / $2,100,000) x 100%

Loan-to-Value Ratio = 77.9%

"I'm sorry, Bubba, but 77.9% loan-to-value, based up the appraiser's estimate of the apartment building upon completion, is too high.  We're going to have to cut your commercial construction loan back to just $1,575,000 - which is 75% of the appraised value.  That means that you will have to come up with an additional $61,400."

Bubba is stumped.  He has already taken Grammy Sara's last dime.  Where is he going to come up with an additional $61,400?  Then Bubba remembers his rich Uncle Kevin.  At first Uncle Kevin wants no part of Bubba's building scheme, but then Bubba reminds Kevin of the time they went out together to the strip joint, and Kevin had gone off to a private room with Bubbles.  "I don't think Aunt Suzy would be too pleased to hear that story, Uncle Kevin."  (Hey, I warned you that Bubba was a slimeball.)  Kevin comes up with the dough and agrees to be a member of the new LLC that Bubba would assemble.

3.  Debt Service Coverage Ratio

The Debt Service Coverage Ratio is defined as the Net Operating Income of the proposed project, as projected by the appraiser, divided by the annual principal and interest payments on the proposed takeout loan.  A takeout loan is just a garden-variety permanent loan that pays off a construction loan.  Remember, the construction loan will just have a 12 to 18 month term.  As soon as the apartment building is constructed and leased out, Bubba will rent it out.  When it is 90% occupied, Bubba will apply to a permanent lender, typically a money center bank, for his takeout loan.

Debt Service Coverage Ratio = Net Operating Income / Proposed Annual Payment on the Takeout Loan

The Debt Service Coverage Ratio is customarily expressed to two digits, such as 1.17 or 1.32.  The Debt Service Coverage Ratio must usually exceed 1.25.  In other words, the projected Net Operating Income, as determined by the independent appraiser selected by the bank, must be at least 125% of the annual principal and interest payment on the proposed takeout loan.

Example Continued:

Bubba returns to the bank with his new $61,400 casier's check from Uncle Kevin, so now he clearly has enough skin in the game - or does he?  "Okay, Bubba," says the commercial loan officer at the bank, "Now we have to look at the Debt Service Coverage Ratio test.  "More tests?" thinks Bubba, "You killin' me here, Smalls."  "Let's see if your deal passes the Debt Service Coverage Ratio test," continues the loan officer.  "We'll assume that your takeout loan will probably have an interest rate of 5.0% and a 25-year repayment amortization.  Plugging in a $1,575,000 loan amount, a 5% annual interest rate, and a 25-year amortization term into my financial calculator, I get an annual principal and interest payment on your expected takeout loan of $111,750.  I see from the appraisal that the appraiser estimated that the property, when completed and leased out, will generate $153,097 in Net Operating Income.  Now let's insert all of the numbers into the formula and see what Debt Service Coverage Ratio that we get."

Debt Service Coverage Ratio = Net Operating Income / Proposed Annual Payment on the Takeout Loan

Debt Service Coverage Ratio = $153,097 / $111,750

Debt Service Coverage Ratio = 1.37

"Okay," says the bank loan officer, "a Debt Service Coverage Ratio of 1.37 is good.  All it had to be was larger than 1.25.  You're good here, Bubba."  "Thank goodness," thinks Bubba, "I was running out of people to con or blackmail."

 4.  Profit Ratio

Just about the last thing that a bank wants is for the developer to skip out of town before completing a project.  This most frequently happens when the developer runs into cost overruns, and the developer realizes that there is no point in completing the construction.  He won't be able to sell the property at a profit anyway because of the cost overruns.  Banks therefore insist on verifying first that the developer stands to earn a good projected profit going into the deal, just in case there are cost overruns.  If the projected profit is huge, then the developer has a capitalistic incentive to stick around, even if there are cost overruns.

The Projected Profit of a construction project is the Value of the Property Upon Completion minus the Total Cost.

Projected Profit =  Value of the Property Upon Completion - Total Project Cost

The Profit Ratio is defined as the Projected Profit divided by the Total Cost, all times 100%.  The general rule is that bankers want the Profit Ratio to be larger than 20.0%.

Profit Ratio = (Projected Profit / Total Cost) x 100%

Example Continued:

"Now let's look at the Profit Ratio," says the bank loan officer.  Bubba fidgets and squirms.  "First let's compute your Projected Profit."

Projected Profit =  Value of the Property Upon Completion - Total Project Cost

Projected Profit =  $2,100,000 - $2,045,500

Projected Profit =  $54,500

"Now that we have the Projected Profit, we can compute the Profit Ratio."

Profit Ratio = (Projected Profit / Total Cost) x 100%

Profit Ratio = ($54,500 / $2,045,500) x 100%

Profit Ratio = 2.7%

Holy mackerel!  This is a poorly conceived project.  Even if there are no cost overruns, this apartment building will only be worth 2.7% more than it will cost to build.  Yikes.  It should be worth a minimum of 20% more than its cost to construct.  As the bank loan officer ponders the disappointing results of this Profit Ratio test, Bubba invites the banker out for "a drink or two" at his favorite watering hole, the local gentlemen's club.  After Bubba has lavished the banker with numerous drinks and several lap dances from the lovely ladies, the weakened banker admits, "You know, Bubba, I like you.  The truth is that our Loan Committee seldom checks the Profit Ratio.  I certainly am not going to bring up the Profit Ratio before Loan Committee.  But we have one more financial ratio that we need to address."

 5.  Net-Worth-to-Loan-Size Ratio

The Net-Worth-to-Loan-Size Ratio is defined as the Net Worth of the Developer divided by the Construction Loan Amount.  This ratio must exceed 1.0.  In other words, the developer needs to be worth more than the amount of the construction loan.   After all, a bank doesn't want borrowers with a modest $800,000 net worth borrowing $5 million from the bank.  What if the loan goes bad?  What if there is a cost overrun?  What if apartment rents plummet while the apartment building is under construction?  If the borrower's net worth is only $800,000, what could he possibly sell to raise enough cash to rescue a $5 million project?

Net-Worth-to-Loan-Size Ratio = Net Worth of the Developer / Construction Loan Amount

 Example Continued:

The bank loan officer says the next morning, "The last ratio that we need to satisfy is the Net-Worth-to-Loan-Size Ratio.  Let's look at your financial statement, Bubba.  It says here that you have a net worth of $452,000.  Let's plug that number into the formula.

Net-Worth-to-Loan-Size Ratio = Net Worth of the Developer / Construction Loan Amount

Net-Worth-to-Loan-Size Ratio = $452,000 / $1,575,000 

Net-Worth-to-Loan-Size Ratio = 0.29

"Hey, Bubba, we have a big problem here.  While Loan Committee will probably not catch the Profit Ratio test failure, they certainly will catch the failure of Net-Worth-to-Loan-Size Ratio.  You desperately need a co-borrower, someone with a big net worth."  Bubba sits down again with Uncle Kevin.  "Uncle Kevin, I can't do this project alone.  My net worth isn't large enough."  "Then give me back my $61,400," shouts Uncle Kevin.  "I'm sorry, Uncle, but I already spent it on the architect and the engineer.  They have already completed their work, so they won't give it back.  Unless you personally guarantee the construction loan, your $61,400 is gone forever."  Uncle Kevin complains bitterly, but he pledges his $5 million net worth towards repaying the construction loan, and the deal finally funds.

Outcome of the Story:

Half-way through construction, Tesla Motors announces its plan to build another battery giga-plant in Bubba's small town.  Rents skyrocket, and Bubba's new apartment building becomes a gold mine.  Uncle Kevin make sure that both he and sweet Grammy Sara get repaid in full, along with a share of the profit.  Uncle Kevin personally walks Grammy Sara's check down to the high-cost mortgage company that refinanced her home, and he refuses to leave until he has a Deed of Recoyenance (proof that the loan has been paid off) in his hands.

Seven months later Bubba is killed in a freak accident.  He is hit by a meteor that hadn't completely burned up in the atmosphere.  Only two people attend his funeral, sweet Grammy Sara and... a well-built, bleach bottle blonde named Lola La Boom-Boom.


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