How Do Commercial Construction Loans Work? The Complete Guide to Funding Your Project
Reading Time: 10 min read
Whether you're building an office complex, retail center, industrial facility, or mixed-use development, understanding how commercial construction loans work is essential before breaking ground. Unlike traditional mortgages that fund completed properties, construction loans operate on an entirely different model designed around the unique risks and cash flow needs of building projects.
In this comprehensive guide, we'll walk you through every aspect of commercial construction financing—from application through final completion—so you can approach your project with confidence.
Commercial Construction Loans: The Fundamentals
A commercial construction loan is a short-term financing vehicle designed specifically to fund the building of income-producing or owner-occupied commercial properties. Rather than receiving one lump sum at closing, you receive funds incrementally as construction progresses through a system called "draws."
This structure exists for good reason: lenders want to ensure their money is being used as intended, and they need to verify that construction is progressing according to plan before releasing additional funds.
Commercial Construction Loan Key Figures
12-36 months
Typical Loan Term
Construction period
65-80%
Loan-to-Cost
Of total project cost
Prime + 1-3%
Interest Rate
Variable during build
5-7 average
Draws
Inspection-based releases
Key Characteristics That Set Construction Loans Apart
Short-Term Duration: Commercial construction loans typically run 12-36 months, depending on project complexity. This covers the building period only—you'll need permanent financing once construction is complete.
Progressive Funding: Funds are released in stages (draws) tied to construction milestones. You might receive 15% at closing for land and pre-construction costs, another 15% when the foundation is complete, and so on.
Interest-Only Payments: During construction, you pay interest only on the amount you've drawn—not the full loan amount. This keeps payments manageable when the property isn't yet generating income.
Higher Interest Rates: Expect rates 1-3% higher than permanent commercial mortgages. Construction loans carry more risk since there's no completed building as collateral until the project finishes.
Inspection Requirements: Each draw request triggers a third-party inspection to verify work completion before funds are released.
The Complete Construction Loan Process: From Application to Keys
Understanding the full lifecycle of a commercial construction loan helps you plan timelines, prepare documentation, and avoid surprises that could delay your project.
The Commercial Construction Loan Lifecycle: From Application to Completion
Pre-Qualification & Application
Submit project overview, financial documents, and construction plans. Lender evaluates borrower qualifications, project feasibility, and provides preliminary terms.
2-4 weeks
Underwriting & Appraisal
Deep-dive review of financials, contractor qualifications, and market analysis. Appraisal determines 'as-completed' value. Loan commitment issued.
3-6 weeks
Closing & Initial Funding
Sign loan documents, establish escrow accounts, and receive initial draw for land acquisition or pre-construction costs. Construction can begin.
2-3 weeks
Construction & Draw Process
Build according to schedule, request draws at milestones, lender inspects progress before releasing funds. Pay interest only on amounts drawn.
12-24 months
Completion & Conversion
Obtain Certificate of Occupancy, final inspection, and convert to permanent financing or pay off the construction loan as agreed.
4-8 weeks
Phase 1: Pre-Qualification and Application (2-4 Weeks)
The journey begins with assembling your application package. Lenders will evaluate:
Project Documentation
- Detailed architectural plans and specifications
- Construction budget with line-item breakdown
- Project timeline with milestones
- Contractor bids and qualifications
- Environmental studies and engineering reports
- Zoning approvals and permit status
Borrower Qualifications
- Personal and business financial statements
- Tax returns (typically 2-3 years)
- Credit reports for all guarantors
- Construction experience and track record
- Entity documentation (LLC, corporation, etc.)
Market Feasibility
- Market analysis demonstrating demand
- Comparable property data
- Pre-leasing commitments (if applicable)
- Exit strategy and permanent financing plan
The more complete your application, the faster you'll move through underwriting. Incomplete packages are the number one cause of delays.
If you're exploring vertical construction financing for multi-story buildings, be prepared for additional scrutiny on structural engineering and contractor capabilities.
Phase 2: Underwriting and Appraisal (3-6 Weeks)
Once your application is submitted, the lender's underwriting team conducts a deep-dive analysis:
Financial Underwriting Underwriters verify income, assets, and liabilities. They calculate key ratios including:
- Loan-to-Cost (LTC): Typically 65-80% of total project cost
- Loan-to-Value (LTV): Based on "as-completed" appraised value, usually 70-80%
- Debt Service Coverage Ratio (DSCR): Projected NOI divided by debt service, typically 1.25x minimum
Appraisal A commercial appraiser evaluates your project in two ways:
- As-Is Value: Current value of the land/existing structures
- As-Completed Value: Projected value once construction is finished
The as-completed value is crucial—it determines your maximum loan amount. Appraisers analyze comparable sales, rental rates, cap rates, and construction costs to arrive at this figure.
Contractor Evaluation Your general contractor undergoes scrutiny too. Lenders want to see:
- Valid licensing and insurance
- Financial stability (bank references, credit)
- Track record of similar projects
- References from past clients
- Bonding capacity
A weak contractor is a leading cause of construction loan denials. Choose wisely.
Phase 3: Closing and Initial Funding (2-3 Weeks)
Upon approval, you'll receive a commitment letter outlining all terms and conditions. Review this carefully—negotiate if needed—then proceed to closing.
At closing, you'll sign loan documents including:
- Promissory note
- Deed of trust/mortgage
- Construction loan agreement
- Assignment of plans and contracts
- Personal guarantees (if required)
The initial draw is released at closing, typically covering land acquisition (if not already owned) and pre-construction costs like permits, architectural fees, and site preparation.
Escrow Accounts Your lender will establish several accounts:
- Construction Escrow: Holds loan proceeds for future draws
- Interest Reserve: Funds set aside to cover monthly interest payments during construction
- Contingency Reserve: Cushion for unexpected cost overruns (typically 5-10% of budget)
Phase 4: Construction and the Draw Process (12-24 Months)
This is where construction loans fundamentally differ from other financing. You don't just receive money and build—you follow a structured draw process throughout construction.
How the Draw Request Process Works
Milestone Reached
Contractor completes a designated phase of construction (e.g., foundation complete, framing done, rough-in finished) as outlined in the draw schedule.
Ongoing
Draw Request Submitted
Borrower or contractor submits formal draw request with supporting documentation, invoices, lien waivers from subcontractors, and progress photos.
1-2 days
Inspection Scheduled
Lender dispatches third-party inspector to verify work completion matches draw request. Inspector documents progress and confirms quality.
3-5 days
Approval & Title Update
Lender reviews inspection report, verifies budget alignment, and title company confirms no new liens filed against the property.
2-3 days
Funds Released
Approved draw amount is wired to borrower or directly to contractor/suppliers. New loan balance begins accruing interest.
1-2 days
How Draws Work
Your construction loan agreement includes a draw schedule—a breakdown of how loan proceeds will be released at specific milestones. A typical schedule might look like:
Typical Commercial Construction Draw Schedule ($2M Office Building)
| Draw # | Phase | % of Loan | Amount | Cumulative Balance | Monthly Interest* |
|---|---|---|---|---|---|
| 1 | Land & Pre-Construction | 15% | $300,000 | $300,000 | $2,100 |
| 2 | Foundation & Site Work | 15% | $300,000 | $600,000 | $4,200 |
| 3 | Structural & Framing | 25% | $500,000 | $1,100,000 | $7,700 |
| 4 | Mechanical/Electrical/Plumbing | 20% | $400,000 | $1,500,000 | $10,500 |
| 5 | Interior Build-Out | 15% | $300,000 | $1,800,000 | $12,600 |
| 6 | Final Finishes & Punch List | 10% | $200,000 | $2,000,000 | $14,000 |
Note: Monthly interest calculated at 8.4% annual rate for illustration purposes. Actual rates vary.
The Draw Request Cycle
When you reach a milestone:
-
Request Submission: Submit a draw request form with supporting documentation—invoices, lien waivers from subcontractors, updated photos, and budget reconciliation.
-
Inspection: The lender sends a third-party inspector to verify the work is complete and matches the draw request. Inspections typically cost $150-$350 each (usually paid by the borrower).
-
Title Update: The title company confirms no new liens have been filed against the property since the last draw.
-
Approval: The lender's construction manager reviews the inspection report and approves the draw (or requests corrections).
-
Funding: Approved funds are wired—either to you, your contractor, or directly to suppliers/subcontractors depending on your loan agreement.
Timing Matters The draw process typically takes 7-14 days from request to funding. Factor this into your project schedule. Contractors need to be paid, and delays in draws can slow construction and strain relationships.
Phase 5: Completion and Conversion (4-8 Weeks)
As construction wraps up, you'll go through final completion procedures:
Final Inspection A comprehensive inspection verifies all work is complete per plans and specifications. Any punch list items must be addressed before final draw release.
Certificate of Occupancy You must obtain a CO from the local building department, confirming the building meets code and is safe for occupancy.
Retainage Release That 5-10% withheld from each draw? It's released after final completion, typically following a 30-60 day lien-free period to ensure no subcontractor claims emerge.
Permanent Financing Conversion Most construction loans require refinancing into permanent (long-term) financing at completion. You have two options:
-
Construction-to-Permanent Loans: A single closing covers both phases. At completion, the loan automatically converts to permanent financing at pre-agreed terms.
-
Separate Permanent Loan: You close a new permanent loan to pay off the construction loan. This requires a new application, appraisal, and closing costs—but allows you to shop for the best terms at that time.
Use our commercial mortgage calculator to estimate your permanent financing payments based on completed project value.
Understanding Construction Loan Interest
Interest on commercial construction loans works differently than traditional mortgages, and understanding this structure helps you budget accurately.
Construction Loan Interest vs. Traditional Mortgage
Construction Loan Interest
- Interest-only payments during construction
- Pay only on funds actually drawn
- Variable rate tied to Prime or SOFR
- Rates typically 7-11% during build phase
- Interest reserve can cover payments
- Resets to new terms at conversion
Permanent Mortgage Interest
- Principal + interest (amortizing) payments
- Pay on full loan balance from day one
- Fixed or adjustable rate options
- Rates typically 1-3% lower than construction
- No interest reserve needed
- Stable payments for full loan term
Interest-Only During Construction
You pay interest only—no principal—during the construction phase. This keeps payments manageable when the building isn't yet generating income.
However, you only pay interest on funds actually drawn. If you have a $2 million loan but have only drawn $600,000, your interest payment is based on $600,000.
Example Calculation
- Loan Amount: $2,000,000
- Current Balance (drawn): $600,000
- Interest Rate: 8.5% annual
- Monthly Interest: $600,000 x 8.5% / 12 = $4,250
As you draw more funds, your monthly interest payment increases proportionally.
Interest Reserve Accounts
Most commercial construction loans include an interest reserve—essentially a portion of your loan set aside to cover monthly interest payments during construction.
How It Works Say your $2 million loan includes a $150,000 interest reserve. Each month, the lender automatically deducts your interest payment from this reserve rather than requiring you to pay out of pocket. This preserves your working capital during construction when the property isn't generating income.
Planning Considerations
- Interest reserves are part of your loan amount (you pay interest on them too)
- Factor the reserve into your down payment calculations
- If construction takes longer than expected, you may need to fund interest out of pocket once the reserve depletes
Critical: Understanding Holdback and Retainage
Most commercial construction loans include a 5-10% retainage (holdback) on each draw. This means if you request $100,000, you may only receive $90,000-$95,000 initially. The retained funds are released after final completion, passing inspections, and the lien-free period expires. This protects the lender from incomplete work or contractor disputes. Plan your cash flow accordingly and ensure your contractor understands this structure.
What Lenders Evaluate: The Four Pillars of Construction Loan Approval
Commercial construction lenders assess four primary areas when evaluating your loan request:
1. The Borrower
Your financial strength, experience, and track record matter significantly.
- Net Worth: Most lenders require net worth equal to or greater than the loan amount
- Liquidity: Cash reserves to cover potential overruns (typically 10-15% of project cost)
- Experience: Construction or development experience, especially with similar projects
- Credit History: Minimum 680 score for most lenders, 720+ for best terms
2. The Project
Is this a well-planned, feasible project?
- Location: Market strength, demographics, accessibility
- Design: Appropriate for the intended use and market
- Budget: Realistic costs with appropriate contingency
- Timeline: Achievable schedule with weather/delay buffers
- Permits: Zoning approval and permit status
3. The Contractor
Your general contractor is essentially a co-borrower in the lender's eyes.
- Qualifications: Licensing, insurance, bonding
- Experience: Track record with similar projects
- Financial Stability: Can they weather delays or disputes?
- References: Verifiable completed projects
4. The Exit Strategy
How will you repay this loan?
- Permanent Financing: Most common—convert to long-term mortgage at completion
- Sale: Sell the completed property to repay the loan
- Lease-Up: Stabilize occupancy then refinance based on income
- Business Cash Flow: For owner-occupied properties, business income services the permanent loan
Types of Commercial Construction Loans
Not all construction financing is identical. The right structure depends on your project type, borrower profile, and long-term plans.
Traditional Bank Construction Loans
Offered by commercial banks and credit unions. Best for borrowers with strong financials and banking relationships. Typically offer the most competitive rates but have stricter requirements.
SBA Construction Loans
The SBA commercial construction programs (particularly SBA 504) offer favorable terms for owner-occupied properties. Lower down payments (as low as 10%) and longer terms, but more paperwork and longer processing times.
Private/Hard Money Construction Loans
Offered by private lenders and debt funds. Higher rates (10-14%) but more flexible underwriting. Ideal for borrowers with credit challenges, tight timelines, or unconventional projects.
Construction-to-Permanent Loans
Single closing covers both construction and permanent financing. Eliminates refinancing risk and saves on closing costs. Available from many lenders for qualifying projects.
Bridge-to-Construction Loans
For projects requiring land acquisition or entitlement work before construction. Bridge loan funds pre-development, then converts to construction financing once permits are secured.
Common Challenges and How to Navigate Them
Even well-planned projects encounter obstacles. Here's how to handle common construction loan challenges:
Cost Overruns
Construction costs exceeding budget is the most frequent issue.
Prevention: Build a 10-15% contingency into your original budget. Verify contractor bids against market rates. Lock in material prices where possible.
Solution: If overruns occur, you may need to inject additional equity, value-engineer the project, or request a loan modification (difficult but possible for moderate overruns).
Construction Delays
Weather, permit issues, material shortages, and labor problems can extend timelines.
Prevention: Build buffer time into your schedule. Secure permits before closing. Use established contractors with reliable subcontractor relationships.
Solution: Request a loan extension (most lenders accommodate reasonable extensions with modification fees). Ensure your interest reserve can cover additional months.
Draw Disputes
Disagreements between you, your contractor, and the lender over draw amounts or work completion.
Prevention: Clear communication and detailed draw schedules. Document everything with photos and written records. Use an experienced construction manager.
Solution: Work directly with the lender's construction manager to resolve disputes. Consider bringing in a third-party inspector for independent verification.
Contractor Issues
Contractor financial problems, poor performance, or disputes can derail projects.
Prevention: Thoroughly vet contractors before starting. Check references, verify insurance, review financial statements. Use progress-based payments rather than front-loading.
Solution: If you must replace a contractor mid-project, involve your lender immediately. They may have requirements around contractor changes.
Preparing for Your Commercial Construction Loan Application
Ready to move forward? Here's how to position yourself for the smoothest possible approval:
Assemble Your Team
- Experienced general contractor (vetted and qualified)
- Architect with commercial experience
- Civil engineer (for site work)
- Real estate attorney
- Commercial loan broker (optional but valuable)
Prepare Documentation
- Complete architectural plans and specifications
- Detailed construction budget (line-item format)
- Project timeline with milestones
- Your financial statements and tax returns
- Entity documents (if using LLC/corporation)
- Market analysis and feasibility study
Know Your Numbers
- Total project cost (land + hard costs + soft costs)
- Loan amount you're requesting
- Down payment/equity you're contributing
- Projected NOI and DSCR upon completion
- Exit strategy and permanent financing plan
Address Potential Concerns Proactively
- Credit issues? Explain circumstances and show improvement
- Limited experience? Highlight your contractor's track record
- Challenging market? Provide data supporting project demand
Frequently Asked Questions
How long does it take to get a commercial construction loan? Expect 6-12 weeks from application to closing for a well-prepared borrower with complete documentation. Complex projects or challenging borrower profiles may take longer.
What credit score do I need? Most lenders require 680+ for principals and guarantors. Scores of 720+ significantly improve rates and terms. Some private lenders work with lower scores at higher rates.
How much down payment is required? Typically 20-35% of total project cost, depending on project type, borrower strength, and lender. SBA programs may require as little as 10% for qualifying projects.
Can I act as my own general contractor? Rarely for commercial projects. Most lenders require a licensed, experienced GC with a track record of similar projects. Owner-builder arrangements increase perceived risk significantly.
What happens if I go over budget? You'll typically need to inject additional equity to cover the shortfall. This is why contingency reserves are critical. Significant overruns may require loan modification or additional financing.
Do I pay interest during construction? Yes, but only on funds actually drawn—not the full loan amount. Most loans include an interest reserve to cover these payments without requiring out-of-pocket contributions during the build phase.
Can I lock in permanent financing terms at construction closing? With construction-to-permanent loans, yes—your permanent rate is established at closing (or based on a formula tied to market rates at conversion). Separate permanent loans require a new rate lock at that time.
Take the Next Step
Understanding how commercial construction loans work puts you ahead of most borrowers who approach this process unprepared. The key to success? Thorough preparation, realistic planning, and working with lending professionals who specialize in construction financing.
Ready to discuss your commercial construction project?
- Apply for your construction loan to start the pre-qualification process
- Use our commercial mortgage calculator to estimate financing costs
- Contact our construction loan specialists for personalized guidance on your specific project
Whether you're building your first commercial property or adding to an existing portfolio, our team has the expertise to structure financing that works for your project timeline and budget.
Have questions before you apply? Speak with our team for a no-obligation consultation.
About Clear House Lending: We specialize in commercial construction loans for developers and business owners nationwide. From ground-up development to major renovations, our construction lending team has the expertise to guide your project from application through completion.
This article is for informational purposes only and does not constitute financial advice. Loan terms, requirements, and availability vary by project, borrower qualifications, and market conditions.