As you evaluate how you would like to craft new construction loans, consider these key factors to take you from land acquisition to completion.

New residential development has become a natural part of the trajectory for investors who start with renovation and graduate to a more advanced understanding of the construction and rebuild processes. As existing inventory continues to diminish, and profit becomes slimmer on flips, knowledgeable investors across the United States are seeking out tear‑down and vacant land opportunities.

To accommodate these investors, business purpose lenders are following suit by offering construction financing, either as an extension of their rehab programs or as a new loan product. But when taking on this financing risk, just exactly what should a lender take into consideration?

Although the risks inherent in construction lending may be perceived as greater than the risks of a traditional flip, in many ways, new development is often a more straightforward process.

As you evaluate how you would like to start lending on new construction loans, here are the key factors to take into consideration.

Land Risk

It’s important to decide how much land exposure you want during the loan’s term. The lowest land exposure risk exists with developed infill lots and tear-down projects. The 2020 Annual Builder Practices Survey (ABPS) showed that 25% of new detached single-family residences across the U.S. were infill lots or tear-downs.

Infill lots are commonly defined by their location in a developed neighborhood or city surrounded by similar asset types. These plots of land typically require few or no horizontal improvements (e.g., digging trenches for utilities or heavy grading) before they’re ready to “go vertical” or the foundation work begins.

The land risk for both developed lots and tear downs can be mitigated by setting clear underwriting guidelines that detail what is acceptable for your company. Requiring permits prior to your loan’s closing date, especially on tear downs that can have permits and plans trailing, helps reduce scope-of-work changes after close. As construction continues at the property and major milestones are completed (e.g., framing), your loan-to-value will slowly decrease as the value of the asset increases.

Loan Length

The length of the loan is a key decision you must make. Your decision depends on whether your firm balance sheets your loans or may sell them during servicing.

Construction timelines can vary wildly, depending on the type of project (e.g., undeveloped land, developed land, tear downs, mid-construction, multi-lot development, etc.), but you should always request a clear timeline for milestones, preferably on a construction schedule.

Most residential 1-4 units can be completed, and loans exited, in the 12- to 24-month terms commonly offered by bridge lenders. Always communicate clearly with the borrower about their expectations of the timeline and adjust the loan terms accordingly.

Extensions

In the wake of the pandemic, it became more important to investors to have extension options for natural disasters and other circumstances outside their control. Major MSAs across the U.S. have seen a backlog of permit submissions that have pushed entitlement and zoning approvals back by weeks, and even months, in 2022. In addition, rising gas prices and difficulty with material procurement have resulted in construction project delays.

As you think about your construction products, consider extension terms and language that allow the developer to complete the project if they have progressed normally outside of these delays.

Asset Types

The next step is deciding which assets you’re going to start with. Depending on your market(s), you may find that density is a driving factor for new construction and, therefore, choose small or large multifamily projects. If you plan to focus on a product you can combine into a future DSCR product, 1-4 unit residential could be your niche at launch. You can expand your product and add complexity (e.g., lot-splits and subdivision loans) as your organization becomes more comfortable in this space.

Execution Strategies

The goal for a construction loan is to ensure the borrower can successfully complete the project and exit your loan. Once the borrower has received a certificate of occupancy, the most popular strategies are to either place the property on market or keep it for a rental.

You should review a market sale loan to ensure that absorption of the type and size of the property is satisfactory and fits in the market. For properties that will be retained as rentals, you can either underwrite them to the asset resale or to an adequate debt service coverage ratio on exit.

Qualification Criteria

You will also need to decide who your product is for; in other words, set the qualification criteria.

Experience is a key factor you should consider in your qualification process. Working with a borrower (and/or their general contractor) who has experience in the asset class and type of construction the project calls for can be the difference between a project completed successfully within budget and a project riddled with delays and budget increases.

Liquidity Reserves

The amount of funds your borrower has available verifies your borrower’s ability to reach major construction milestones before a draw is provided. Consider how your construction draw management will work, and set expectations in your guidelines accordingly. For instance, if your company provided only draws in arrears, you may want to consider having the borrower show 20%-25% of the construction budget in liquidity to ensure subcontractors get paid before the draw submission.

Minimizing Risk

Unlike rehab projects, most states require a general contractor’s license to build a new home. It’s an important step to ensure your team, or a third-party construction loan administrator, understands the limits you place in your underwriting box and where your tolerances for exceptions stand. Conducting background checks, permit lookups, general contractor license searches, and reviews of previous projects the contracted GC group has completed are all ways to minimize risk on the project.

As land becomes scarcer and developers continue to expand into newer developable areas on the fringes of MSAs, you can add new products to increase your reach to these investors. As your team gets more comfortable with 1-4 residential, expansion into multi-lot development and more complex residential projects become easier to embrace.

By developing products that follow the trajectory of your repeat clients’ business, you not only help retain the investor, but create a path for new and more experienced individuals to work with your company.