How does construction finance work?

The challenges faced by small and medium sized enterprises (SMEs) in the construction industry are quite different from those faced by SMEs in other industries. The funding options available to these businesses, also known as construction finance, are designed to suit the specific requirements of construction companies, architects, developers, and brokers.

However, the particular way they work often leaves those seeking construction finance with questions. If you are seeking answers to the question, how does construction finance work, this guide will help to explain how this unique type of funding can be used to tackle the working capital constraints and challenging payment gaps which are often inevitable hurdles in any major construction project.

What is Construction Finance?

Construction projects require a lot of capital and construction finance can help businesses in this industry to fund capital intensive projects and turn your vision into reality. They are essentially short-term loans which are generally used when a project entails construction of a new building on a vacant site.

With the help of this finance, businesses can take on projects which they wouldn’t have considered due to lack of capital. It also allows you to work on multiple projects simultaneously. However, as a builder you shouldn’t give lenders the impression that you are taking on too much at once.

If you require finance for a project which has already been completed, you can try other options which may be more suited to your needs, such as financing a property portfolio or commercial property finance.

Construction Finance

How Does Construction Finance Work?

There are several types of finance which can be used by developers, contractors or businesses if you require funding to build. A construction loan is typically a short-term loan which is usually taken out for the duration of a year to cover the costs of building a structure on a vacant plot of land.

The projected value of the developed property determines the amount of finance which is likely to be offered to you, and it is one of the most important factors on which basis a loan application is approved or denied. When the structure has been erected, the loan can be repaid by selling the property, or another long-term financing option such as a mortgage can be used to repay the loan.

A common structure which is adopted by most lenders is to advance funds to a borrower in stages, based on predefined milestones in the project. The following are common stages at which funds are generally released to a builder:

  • Upon approval of the loan
  • When the foundation of the structure has been laid
  • Upon completion of the structure
  • When the walls and roof have been completed

It is usually possible to negotiate the disbursement terms with your lender and agree on a schedule which is suitable for you. These terms need to be clearly understood by the lender as well as the borrower because any delay in receiving payments can delay the project. If you are a subcontractor or builder and you are not the owner of the property you are working on, you may still require finance to complete your job.

Payment terms used by businesses in the construction industry can often be as long as 90 days or even more. This means that while you are spending a substantial amount on materials and wages in the initial stages, you will probably not be receiving any income. Not receiving payments for your outstanding invoices can impact your financial ability to continue with the project.

To solve this issue, lenders now provide alternate types of finance such as cash flow finance and invoice finance. These types of finance allow construction subcontractors to sell their outstanding invoices to a lender, meaning quick access to funds when they’re needed.

If you need finance for a specific requirement such as to buy additional equipment, such as construction machinery or vehicles, you can try other alternatives such as asset finance for these types of acquisition.

Unsecured loans or business loans can also be used to pay for construction projects. However, such loans do not tend to have the flexible repayment terms which are offered by construction finance. As any big building project is not likely to generate an income for you as the builder in the immediate future, these types of loans may not be particularly suited for construction SMEs.

Is Any Collateral Required for Construction Finance?

There are several challenges involved in the process of qualifying for a construction loan. However, much to the relief of construction SMEs, additional security is not required to secure construction finance.

The property which is being developed serves as collateral for the loan. When it comes to vehicle leases, equipment leases and asset finance, the asset being financed is used as collateral for the loan.

How Much Does Construction Finance Cost?

The interest rate charged by the lender varies depending on the degree of risk and the size of the project. For a builder with a good reputation and strong credit history, the interest charged on the loan amount should be only slightly higher than the rates available for commercial borrowing.

Does It Take Long To Secure Construction Finance?

If you have a good credit history, realistic GDV assessments, clear timelines and a detailed plan for your project, then construction finance can be acquired in as little as 24 hours to 48 hours. If there is a high level of risk involved in your construction project or you do not have the necessary documents, you may have to wait longer for the loan to get approved.

Several banks provide construction finance, but they may have stringent criteria regarding the projects they fund. Therefore, it is advisable to consider alternative finance lenders which specialise in construction finance.

The list of criteria that a builder is required to fulfil to qualify for construction loans may vary from lender to lender. Therefore, it is advisable to get quotes from several lenders to find the deal that suits your needs the best, before signing up to anything.