What Is a Construction Loan and How Does It Work?
Construction loans function differently from standard commercial real estate loans. Rather than receiving a lump sum at closing, borrowers access funds incrementally as construction reaches specific milestones. This structure protects both lender and borrower by ensuring capital deployment aligns with verified project progress.
How Construction Loans Are Structured
Construction loans typically span 12 to 24 months with interest-only payments during the building phase. Borrowers don't receive the complete loan amount initially; instead, a lender-appointed inspector visits the site to verify the work before funds are released. Upon construction completion, the loan either converts to permanent financing through a construction-to-perm arrangement or gets retired using a separate takeout loan, a conventional mortgage secured independently.
Types of Construction Loans
- Ground-up construction: New commercial property development financing
- Renovation or gut rehab: Major structural improvements to existing buildings
- Construction-to-perm: Combined loan covering both construction and permanent financing
- SBA construction: SBA 7(a) or 504 loans for owner-occupied commercial property construction
What Lenders Require
- Detailed construction plans and specifications
- Cost breakdown and contractor bids
- Contractor credentials and licensing
- Building permits
- Project timeline
- Borrower experience in construction or real estate development
- Evidence of equity or down payment (typically 20 to 30%)
The Draw Process
Borrowers submit draw requests as work completes. Interest accrues only on the amounts drawn, not the full loan commitment, reducing early-stage carrying costs. Most lenders require a 10 to 15% budget contingency, protecting both their position and project completion capacity.
Takeout Financing
When construction loans lack automatic permanent conversion, borrowers need takeout financing, a conventional CRE mortgage, DSCR loan, or SBA option. Lenders frequently demand takeout commitment letters before releasing construction funds, making advance planning essential.
Who Should Consider Construction Financing?
Construction loans serve borrowers needing ground-up development or substantial renovation without existing property collateral. Though more complex and requiring greater lender oversight than standard purchase loans, they remain the only way to finance ground-up development.
Educational content only, not advice. KQT Advisors, LLC is a commercial loan broker; we are not a lender, attorney, accountant, financial advisor, or fiduciary. We do not originate loans or make lending decisions. The information in this article is provided strictly for general informational and educational purposes and reflects our understanding at the time of writing. It is not, and must not be construed as, financial, tax, legal, accounting, investment, or any other professional advice, and creates no advisor-client relationship. Loan programs, rates, terms, eligibility requirements, fees, and approval criteria are set by individual lenders, the SBA, and other parties and are subject to change at any time without notice. Examples are illustrative only and not guarantees of outcome. Nothing here is a commitment to lend, an offer of credit, or a representation that any specific structure will be available to or appropriate for any borrower. Always consult your own qualified financial, tax, and legal advisors before acting on any information in this article. To the maximum extent permitted by law, KQT Advisors, LLC and its principals, employees, agents, and affiliates disclaim all liability for any direct, indirect, consequential, or incidental loss or damage arising out of any use of, reliance on, or inability to use the information in this article.