At Cuddy & Feder, we represent borrowers in obtaining construction loans and lenders in making construction loans. As we have been on both sides of the construction loan, we generally know what is typical and what to expect in navigating the construction financing process. During the initial term of a construction loan, a borrower typically makes payments of interest only (i.e., not principal) because the property itself is not generating any revenue. The property is not generating revenue because the project is in the process of being built and, therefore, there are no tenants paying rent. Important for any construction lender is the ultimate goal that, not only will the project get fully built but, more importantly, that the project will start generating revenue. This is a critical point for the construction lender because, generally, the repayment of the construction loan will come from the proceeds of a new permanent loan. A lender cannot make a permanent loan unless the property is generating revenue. A property has achieved “stabilization” when the project is generating enough revenue such that it has satisfied various financial tests as determined by each lender on a project-by-project basis, which tests may include debt service coverage ratios and debt yield tests. Since the repayment of a construction loan is from a new permanent loan, the construction lender will generally require that the borrower complete the construction of the project on or before the initial maturity date of the construction loan but will then give the borrower the right to extend the maturity date of the construction loan by a certain period of time to give the borrower time to obtain a permanent loan. Usually, in order to qualify for the extension, the project must have, among other things, achieved stabilization.
A property has achieved ‘stabilization’ when it generates enough revenue to meet financial tests set by lenders, such as debt service coverage ratios and debt yield tests.
What happens if there are construction delays and stabilization has not been achieved prior to the maturity date? The borrower does not qualify for the extension and is facing an upcoming maturity date with the obligation to repay millions of dollars of principal, failing which the lender may exercise any one of its remedies, including foreclosure. Both lenders and borrowers generally try to avoid this scenario and will try to negotiate a loan modification. Borrowers should expect that this modification will be costly. Lenders will generally charge fees and those fees must be paid upfront. If the lender doesn’t already have a personal guaranty of the loan, the lender will likely ask for one as a condition of extending the maturity date. Further, the lender may increase the interest rate either at the commencement of the extended loan term or during the extended loan term if stabilization still hasn’t been achieved by a certain date, or both.
