The journey from constructing to selling property on newly acquired land is an ambitious endeavour that requires significant funding. In the current market, where the funding for the purchase or construction of new homes is at record lows, obtaining a loan involves a meticulous application process, especially where both the purchase of the land and the subsequent construction costs are financed. This article explores the general steps involved in applying for a construction loan, including preparation, application, approval and eventual repayment strategies; however, not all processes mentioned are applicable for every lender within the industry.
A construction or development loan is a short-term, higher-interest loan that provides the financing needed to usually cover the cost of land acquisition and the construction of residential or commercial properties. Unlike standard home loans, construction loans are disbursed in stages (or progress draws) as construction milestones are achieved or on a cost-to-complete basis. Upon completion of the project, these loans can be converted into a permanent mortgage (known as residual stock mortgages) or repaid via the sale of the constructed properties.
Before approaching a lender, it's crucial to have a clear understanding of the project's scope, including the purchase price of the land, construction costs, and the timeline for selling the properties. Developing a detailed business plan that outlines the project's feasibility, expected costs, presale marketing, exit strategies and projected revenue is essential.
Step 1: Review Finances
Lenders will closely scrutinise credit scores, loan-to-value (LVR) ratio, and financial reserves. It's important to review and correct inaccuracies in any credit reports provided to lenders.
Step 2: Assemble Required Documentation
The loan application will require a plethora of documents, including but not limited to:
• Full copy of constitution and trust deed for any trusts involved
• Title details and title plan
• Planning and building permit with endorsed plans
• Proposed subdivision plan
• Signed building contract and specifications
• Site check survey
• Builder's registration certificate
• Builder's history of completed projects
• Builder's warranty insurance and works insurance certificate
• Signed contract of sales for any presales
• Copy of sale / marketing campaign from selling agent
• Balance sheet / profit & loss (P&L) statement for the borrowers and related parties
• 100 points identification for the borrowers and related parties
Step 3: Submit Application Form
The first step in securing financing for the construction project is to complete the application form of the chosen lender with the relevant required documentation. This form is critical for capturing essential details about the business, the borrowers, the desired loan amount, the purpose of the loan, and any real estate assets and liabilities. This initial information is foundational, providing lenders with a snapshot of the financial and business position.
Step 4: Initial Assessment
Upon receipt of the application, the lender conducts an initial review of the provided details. This assessment aims to determine the feasibility of offering a loan under the circumstances outlined in the application. It's a preliminary screening process to ensure alignment between the borrower's needs and the lender's lending criteria.
Step 5: Issue Indicative Letter of Offer or Term Sheet
If the outcome of the initial assessment is positive, the next step involves issuing an Indicative Letter of Offer, which is sometimes referred to as a Term Sheet. This document outlines the potential loan amount, terms, and interest rate the lender is willing to offer. This stage is crucial for borrowers to understand the lender's preliminary conditions and decide if they align with their project's financial requirements. Should the borrower find the offer acceptable, a nominal assessment fee is often required to advance to the next step. The nominal assessment fee, also known as the commitment fee or application fee, is set by the lender and covers the lender of any fees and costs associated with conducting due diligence.
Step 6: Conduct Due Diligence
Due diligence is an in-depth examination of the borrower, project feasibility, proposed loan structure, security position, exit strategy, land value and the potential value of the finished properties. This process can take several weeks or months, depending on the project's complexity and the lender's requirements. This comprehensive review ensures the lender fully understands the risks and opportunities associated with the loan. Borrowers are required to submit a series of documents, as specified in a checklist provided by the lender, to facilitate this detailed assessment.
Step 7: Issue Letter of Offer or Formal Offer
Following a thorough due diligence process, if the loan application meets all the lender's requirements, a formal Letter of Offer is issued. This document specifies the final loan terms, including the interest rate, expected disbursements at settlement, and any conditions that must be satisfied before and after settlement. This step marks the transition from preliminary approval to a formal commitment by the lender to fund the project. To proceed, the borrower is usually required to sign on the Letter of Offer, thereby acknowledging any fees due and payable to the lender at that point in time. Some lenders prefer to lodge a mortgagee caveat (which is withdrawn at settlement) once the Letter of Offer is signed and returned by the borrower as extra security.
Step 8: Settlement
The final step in the loan application process is settlement. Once the borrower accepts the Letter of Offer, loan documents are prepared and sent to the borrower's lawyers electronically. After the borrower's lawyers returns the fully executed documents, the lender can start to prepare for settlement, which is now carried out online (via PEXA) where the borrower's lawyers, the lender's lawyers and the vendor's lawyers come together. Disbursements figures are made available online so that each party knows who is getting paid and who is providing the funds. Once settlement is completed, funds are usually disbursed to the bank accounts on the same day, mortgages are registered immediately, and all relevant parties are notified.
Effective communication between the builder, the borrower and lender is crucial during construction. Regular inspections by the lender, usually through a quantity surveyor will likely be required to release further funds. It's also important to manage construction costs carefully to avoid overruns that could affect the financing. Delays will also affect not only the budgeted construction costs but also the interest on the construction loan. Some lenders organise progress claim groups (PCG), where all relevant parties come together to discuss how the project is going and to flag any issues.
The goal is to sell the properties with a margin to create profit after repaying the loan. Developing a marketing strategy for the sale, understanding the target market, and pricing the properties competitively are key elements for success.
This article provides a brief general overview of the loan application process; however, it's worth noting that each lender may have differing requirements. Thorough preparation, understanding the various loan options, meticulous application, and effective project management are all critical to success. Securing a loan for the purchase of land and constructing properties can be a complex and rigorous process but well-managed projects can be financially lucrative and rewarding.
Image by Frauke Riether from Pixabay
Andy Wong is a co-founder at PropertySensor and has more than a decade of experience diving into Finance and Construction Lending while working at Payton Capital and Australian Securities Limited.