Construction Loans
A construction loan is a short-term loan to a developer for the purpose of acquisition, development, and construction of the property. These loans typically carry high risk because the value of a property might decrease if a project is not completed. Typically to account for these risks, borrowers have recourse loans where they have personal liability for a default.
Another way to mitigate risk is through a draw-down loan. A draw-down loan is where the lender releases finances periodically throughout the loan period when the developer has reached agreed upon checkpoints. For instance, release of a certain amount to acquire the property. Once property is acquired, release a certain amount to finance development. Then release more once zoning has been made, etc. Failure of the developer to meet one of these checkpoints will result in a default.
Permanent Loans
These are long-term loans usually between 10–30 years long. These loans are made after construction is completed and are designed to evaluate the potential level of success of a property. The developer gets paid by the development, who in turn uses that income to pay off the loan. A lender will then be required to evaluate the continued success of the management to ensure that the loan will not go into default.
Take-Out Arrangements and Three-Party Agreements
A take-out occurs when the developer has finished construction and rolls over the remaining balance on the construction loan into a permanent loan. That is, the permanent lender takes out the construction lender in the transaction by paying off the construction lender’s balance.
There are three types of take-out agreements:
- Locked in: Permanent lender has already committed to take over the construction loan.
- Stand-by: A developer hopes that there is no need for a permanent lender but has one ready to take over the construction loan if needed.
- Open-ended: There is no permanent lender ready to take over the construction loan and instead both the developer and the construction lender hope that a permanent lender will be available in the future.
The agreement that facilitates the relationship and obligations between the developer, construction lender, and permanent lender is a three-party agreement.
In other words, this whole process outlines how commercial financing occurs. Here is a step by step:
- Developer has an idea
- Developer acquires property through a loan or contract
- A permanent lender is secured (hopefully with ai lock-in commitment
- A construction lender is secured
- The parties execute a three-party agreement
- The developer closes on the construction loan and begins construction
- Construction is complete
- The permanent lender takes out the construction lender
- Income is produced from the project (either by sale or use) and the main focus is property management.
Teachers Insurance & Annuity Association v. Ormesa Geothermal
791 F. Supp. 401 (S.D.N.Y. 1991).
Ormesa is a developer a a geothermal plant and sought financing for the development. Teachers Insurance & Annuity Association (TIAA) was among those interested in providing the financing. Together, the parties determined a fix rate and it was custom not to adjust the rate once agreed upon. A few months after the agreement, the market interest rate went down. If Ormesa could have an interest rate at the new market price, then it would save over $1,000,000 a year. Finding that it would be cheaper to breach the contract and walk away to a new lender, Ormesa failed to negotiate with good faith. Still trying to find a way out of the contract, Ormesa said the agreement was not binding. This argument was refused by the court. Damages related to this breach is over $4,000,000.
Disclaimer
The content contained in this article may contain inaccuracies and is not intended to reflect the opinions, views, beliefs, or practices of any academic professor or publication. Instead, this content is a reflection on the author’s understanding of the law and legal practices.
