Construction Loan
A construction loan is a short-term, interest-only loan used to finance the costs of building or substantially rehabilitating a commercial or residential property, with funds disbursed in stages as construction progresses and typically replaced by permanent financing once the project is completed and stabilized.
Construction financing is fundamentally different from traditional real estate mortgage lending because the collateral — the completed building — does not yet exist at the time the loan is made. Lenders are underwriting both the completed asset value and the developer's ability to successfully execute the construction process on time and on budget, making construction lending a higher-risk and more active form of credit than permanent mortgage financing.
U.S. construction loans are typically structured as revolving credit facilities with a maximum loan amount (the loan commitment) that the borrower can draw down over the construction period. Rather than receiving the full loan proceeds at closing, the borrower submits monthly draw requests supported by architect certifications, contractor invoices, lien waivers, and site inspection reports from a construction monitor retained by the lender. The lender reviews the draw request against the approved construction budget and releases funds in tranches as construction milestones are achieved. This draw structure protects the lender by ensuring funds are released only for completed, certified work.
Construction loans are almost always floating-rate instruments priced at a spread over SOFR (which replaced LIBOR in the U.S. market) or, for smaller community bank loans, over the prime rate. Loan terms typically range from 18 months to 36 months, with extension options sometimes available if construction is delayed. During the construction period, the borrower pays interest only on amounts actually drawn, not the full loan commitment — which reduces carry costs during the early phases of construction.
Lenders assess construction risk across several dimensions: the developer's track record, the general contractor's financial strength and performance history, the completeness and realism of the construction budget and schedule, the absorption assumptions for the completed project, and the loan-to-cost and loan-to-value ratios at completion. Recourse provisions in construction loans are more common than in permanent financing, as lenders want the developer's personal guarantee of completion given the execution risks inherent in construction.
Once construction is complete, the property enters a lease-up or stabilization phase. The construction loan is typically converted to or replaced by a bridge loan or permanent loan once the asset achieves a defined occupancy threshold. The timing and terms of this takeout financing are often pre-arranged at the outset of the construction project to ensure the developer has a clear path to refinancing and does not face a maturity default on the construction loan if lease-up takes longer than expected.