Construction Loans: Mechanics and Strategy

For local buyers, construction loans particularly where bank policy falls short

Construction Loans Explained

Unlike standard mortgages where funds are advanced in a lump sum, a commercial facility releases capital as the build advances. This mechanism ensures the lender's exposure remains tied to the actual work completed on site. Payments, known as progress draws, are triggered when specific milestones are reached. These milestones are typically verified by an independent quantity surveyor to ensure the work meets the agreed standard and value before funds are released.

Within this structure, a retention amount is often held back by the lender until practical completion is finalised. This provides a security buffer for the financier. For developers seeking construction, this staged approach offers interest efficiency, as interest generally only accrues on the balance that has been drawn down rather than the total facility limit. This aligns the cost of capital with the actual deployment of funds into the project.

Gearing and feasibility metrics

Lenders assess risk using two primary gearing ratios rather than a single snapshot. The first is the loan to total development cost (LTC), which measures the debt against the cost to build. The second is the loan to gross realisable value (GRV), which measures the debt against the project's end value. A facility that is sized against both metrics provides a clearer view of feasibility than one relying solely on loan to value ratio.

Interest is commonly capitalised within the facility throughout the construction period. This means the interest payments are added to the loan balance rather than paid monthly in cash, assisting with cash flow during the build phase. The total cost is then settled upon completion or refinance. By focusing on the end value and total cost, lenders can better understand the project's profit margin and security.

When non-bank lenders are preferred

Major banks often apply strict policies regarding presale requirements and leverage caps. Projects that fall outside these parameters may require a non-bank approach. These lenders assess deals based on their specific merits and feasibility. Common scenarios where non-bank capital is suitable include projects requiring higher leverage than banks permit, or where a developer wishes to preserve equity and minimise upfront cash contribution.

• Reduced presale cover: Non-bank lenders can often proceed with lower pre-commitment levels from buyers.
• Tight timelines: Settlement dates that do not align with standard bank processing speeds may be accommodated.
• Complex structures: Projects with non-standard attributes or mixed-use components may fit better outside a bank credit template.

While pricing may reflect the higher risk tolerance, the ability to proceed with a feasible project that a bank would decline often justifies the cost of capital.

Senior debt versus development finance

It is important to distinguish between a pure construction facility and broader development finance. A construction loan acts as the senior debt tranche, funding the build costs directly. In contrast, full development finance may layer in additional capital structures such as mezzanine finance or preferred equity to increase the total leverage across both land acquisition and construction.

For projects with strong presales and moderate gearing, a simple senior facility may be sufficient. However, higher-leverage deals often utilise a layered stack. Here, the construction loan sits at the top of the capital stack, with other forms of subordinated debt filling the funding gap to maximise the developer's return on equity. Understanding this distinction helps in selecting the right funding partner for the specific stage and structure of the project.

1. Prepare Feasibility Study. Compile detailed figures on total development cost (TDC) and gross realisable value (GRV) to demonstrate a clear profit margin.
2. Secure Builder and QS. Appoint a qualified builder and engage a quantity surveyor to provide the build program and cost reports required by lenders.
3. Define Exit Strategy. Establish a clear takeout strategy, whether through presales, a refinance to residual stock finance, or a bulk sale upon completion.
4. Submit Application. Present the project to lenders, highlighting strengths like presales, equity contribution, and asset backing to secure favourable terms.

Common questions

How are progress draw funds released? Funds are released in stages as the build progresses. Each draw corresponds to a completed milestone, such as the slab stage or frame completion. A quantity surveyor typically verifies that the work has been done to the required standard before the lender releases the funds for that specific stage.

Why are there two gearing metrics? Lenders use Loan to Cost (LTC) to ensure the debt is sustainable against the build budget, and Loan to Value (GRV) to ensure the final end value covers the debt. Using both provides a complete picture of feasibility and security, protecting both the lender and the developer from cost overruns or market value drops.

What is the benefit of capitalising interest? Capitalising interest means adding the interest cost to the loan balance rather than paying it cash monthly. This improves cash flow during the construction period when the developer has no income from the property, allowing funds to be directed towards build costs and supplier payments.

Guidance on commercial construction funding and development finance structures for property developers.