Construction Financing Trap

Do You Have An Exit Plan For Your Construction Financing?

All construction financing projects have a definite beginning and end.  The beginning is marked by the approval of a construction loan or mortgage to secure capital for building costs.  The end is marked by the retirement of the construction mortgage through another source of capital.

If you plan to keep the property after construction is completed, then you’re going to have to “take out” the construction financing in place with a long term mortgage instrument that will amortize the cost of construction over a long period of time.

When construction mortgages are arranged at the same time as the long term funding, the construction costs will flow from the short term construction financing facility to the longer term property mortgage at the successful completion of the construction project.

However, its also not uncommon that a financed construction project can be well underway without any long term funding lined up.

Many times there is an urgency to get a project started, and once construction funds have been arranged, the project will begin with the thinking that the term out mortgage will be easily acquired towards the end of the project.

But this is not always the case.

When term financing can’t be secured on schedule, the consequences can become rather costly.

Construction loan interest rates tend to be significantly higher than long term mortgage rates.  So at the very least, the cost of the project will go up as the financing costs of the construction mortgage will stay in affect until it can be paid out.

But if term financing proves to be elusive months after successful completion, the borrower can also run the risk of the lender taking action against the property to recover the construction costs.

Construction lenders understand the risks associated with this type of funding and while its not likely their preference to take an action against a borrower to get repaid, they are more than prepared to do so if required.

Not pre-arranging a take out mortgage can be a well calculated risk by a borrower such as a builder who has experience with the process and has  several long term property lenders in the immediate area that would be interested in the finished project.

But in situations where the project takes place in a remote area and the use is somewhat specialized where there is not a highly active reseller market for the property type, term mortgages can be hard to find at times.

Obviously, the best way to avoid the risk is to not commence the project until both the front end and back end funding have been secured.  But if that’s not possible without delaying the project, and the probability of term financing appears to be high,  you may still chose to get started on construction (depending on your risk tolerance of course),  but there should be a continual focus on getting the long term funding pinned down sooner than later.

One of the key reasons problems do occur is that once the project starts, all the attention gets focused on project management, and the efforts related to finding and securing long term financing are redirected or put on hold.   If this activity is delayed too long, there can be serious timing issues at the end of the project.

About the Author Brent Finlay