The construction loan is a short-term financing to fund the building costs of investment properties such as commercial buildings. Since these projects are capital intensive, developers are often unable to fully fund the construction with their own equity. A financing gap arises that needs to be filled with structured debt solutions like mezzanine loans or preferred equity. These instruments are used as gap financing and carry a higher interest rate due to their equity-like features. They allow financing without additional mortgage on the property which is often restricted for senior loans.
Features of commercial real estate construction loans
The construction loan has features like being short-term in tenure to cover building costs, having seniority status over other debt instruments and needing to be refinanced once project stabilizes. The loan to value is often kept less than 75% by lenders based on regulatory requirements. This creates a financing gap that developers cover through junior debt instruments like mezzanine loans or preferred equity which provide flexible options as structured financing solutions.
Mezzanine debt as gap financing instrument
Mezzanine debt is junior to senior loans but senior to equity in priority. It allows financing without additional mortgage as the underlying security is usually LLC interests and personal guarantee of sponsors instead of property. Terms are more flexible relative to bank loans. Mezz debt acts as a bridge between senior loans and equity.
Role of commercial mortgage backed securities
Rise of commercial mortgage backed securities has led lenders to be more conservative and underwrite loans to lower LTVs so that the pools can get investment grade ratings. This contributes to financing gap which allows specialized lenders to provide structured financing through mezzanine loans.
Construction loans leave a financing gap for developers to fill through mezzanine debt or preferred equity as flexible structured financing solutions without additional property mortgage, allowing projects to obtain senior lending and get successfully funded.