Okay, so you’re ready to launch your new business. You have your business model set up, products and services in place, maybe even some staff that you’ve hired. There’s only one thing left to decide: Where are you going to set up shop? While leasing an existing location is always an option, if you’re interested in building a new structure for your home base, this article will help you navigate the challenges of financing new construction.
Financing options for new businesses
Building a structure from the ground up requires a construction loan for most business owners. Construction loans are short-term loans that are used for the sole purpose of financing the new structure. These loans have different funding and repayment terms than traditional business loans. It is important to understand the specific types of construction loans, and their repayment terms, before deciding on the best option for your business.
What can constructions loans be used for?
Eligible expenses for construction loan funds depend on the type of loan, loan amount, and terms, so check with your lender on any use you may be unsure of. Most construction loans can be used for land or other real estate, plans, drawings, and permits. Construction loan funds can also be spent on labor and materials for the structure as well as purchasing equipment that will be used in the construction. Some loans will also cover closing costs, interest reserves, landscaping, and insurance.
Pro tip: Check to see if your construction loan allows for funding a contingency reserve if the project ends up costing more than originally budgeted.
How do construction loans work?
Construction loans work differently than traditional business loans. The funds borrowed in this type of loan are not disbursed upfront in one lump sum but in a series of payments made throughout construction. The release of funds is usually called a draw and often occurs at scheduled milestones throughout the project. Some lenders require that the disbursement schedule remains fixed per the original budget and some loans allow the amount of each draw to depend on the costs during the specified time period. Often an inspection is required before each draw. The purpose of the inspection is to reassure the lender that the work is being done as reported.
What are the different types of construction loans?
Construction-only loans are sometimes called construction mortgage loans, or “two-close” construction loans. They are short-term loans with terms matching the expected completion time of the project. Usually, the lender will cover a portion of the completion costs, with the responsibility for the remainder falling on the borrower. You will be making interest-only payments throughout the life of the loan but be responsible for paying the balance off at the completion date. Options to refinance these loans are available but limited.
This type of construction loan is probably the most common. Construction-to-permanent loans are also called CP loans or “single close” construction loans. They offer the most predictable interest rates because they are locked in at closing. This type of financing combines the construction loan with the mortgage loan, which saves money with only one set of closing costs. Like construction-only loans, only interest is paid during construction. After construction is complete, the loan terms usually call for the borrower to pay interest and principal.
Commercial construction loan
The commercial construction loan is typically used for large projects like an entire office building, hotel, or apartment complex. These loans are offered within the construction industry by select lenders and carry more risk than construction-only or construction-to-permanent loans. Because of the risk, most of the cost of construction must be paid by the borrower or construction business owner.
New business construction challenges
Securing a construction loan for a new business is very challenging. Loans on new construction are high risk for lenders because there is no collateral on the loan, unlike with traditional real estate financing. Because of the risks, lenders require borrowers to provide thorough documentation before getting approved for a construction loan.
Borrowers also face high down payments and high interest rates. Aside from the documentation required for any business loan, the construction loan approval process also often requires multiple inspections and evaluations of all architectural plans and construction schedules. A lender may even ask that you provide some credit history on the construction companies you wish to use.
Even after jumping through all the hoops in the construction loan application process, new businesses may still struggle to get approved for construction loans. If you are working with a lender to get a construction loan you may run into some red tape because of the following factors:
No credit history
Credit history goes beyond evaluating good credit and bad credit. Banks will be hesitant to lend money to a new business. Many lenders want to see at least two years of income and credit history for a business before considering approval. Because new businesses don’t have the credit history required, you may have to rely on your personal credit history to get a loan.
Inconsistent income and cash flow
As a new business owner, it is difficult to show any consistent revenue or cash flow because the business has not been operating long enough. While this lack of history will hold up traditional loans for a small or new business, it is even harder to get around these requirements with construction loans.
Insufficient debt-to-income ratio
Many lenders are not willing to work with new businesses that have taken out any other type of loan because of their debt-to-income ratio. New businesses often lack the income history to support one loan, let alone an additional loan. If you already have financing with a bank or lender to fund the startup of your business, it may be near impossible to secure an additional construction loan.
Nonexistent organizational charts
When applying for construction loans or any business bank loans, lenders will often want to analyze the organizational chart of the business. The organizational chart will list the management team and their role in the company. They use the chart to gauge the integrity of the business. For startups, something as small as a missing org chart may make getting a construction loan more difficult.
Economy and industry trends
As a new business owner, you believe in your idea. You would not start a business in an industry that you believe to be declining. However, lenders have their own set of standards for industry predictions, and they may differ from yours. You may not be able to get a construction loan if the lender deems your business’s industry as declining. Lenders that finance construction loans often take the economy into consideration as well. If the economy is considered unfavorable by financial institutions, getting a construction loan for a new business may not be an option.
Alternative options for new businesses
Construction loans may not be feasible for new businesses, but that doesn’t have to affect your plans for success. The recipe for success as a new business owner often requires a dash of flexibility. Consider your immediate business needs and see if it is possible for you to start operations without new construction, or whether you need to consider alternative financing options for construction.
Explore other financing options
If you are convinced that new construction is a must for your new business plan, you may need to explore business financing options other than banks and traditional lenders. New construction is expensive, and you must also consider how much working capital is required for operations. Investing from your own bank account is an option, although it carries high risks.
Personal loans from friends or family are another option to finance your construction goals. Depending on the eligibility requirements you may also be able to raise capital by invoice financing, equipment financing, or a business line of credit. Some new business owners find that outside investors, personal loans, or even business credit cards may be helpful.
Small businesses often have success working with the loan programs offered by the Small Business Administration (SBA). SBA loans, including the SBA 7, often offer low-interest rates and affordable monthly payments.
Build business credibility without new construction
Most business owners will likely find that they can establish operations in a rented space, building credibility and establishing cash flow along the way. This is also less risky than new construction because if your entrepreneurial idea turns out to be a bust, you won’t be on the line for the construction loan. So before stressing about whether or not you can get approved for a construction loan, consider making these efforts for your new business:
Invest in Marketing
To grow your business, attract customers, and increase revenue, you have to get the word out. Marketing in its most basic form is just getting the right message, to the right people, at the right time. When you first launch your startup, you need to build a brand and get your name in front of potential customers. This is true regardless of your industry. A good rule of thumb is to invest 7-8% of your revenue in marketing, whether that is digital marketing and social media ads, signs and billboards, or radio and TV.
Focus on Customer Service
Loyal customers are the keys to success for any business. Since you only have one chance to launch a startup for the first time, make sure you are providing quality products and services that customers will rave about. This will establish you as a trusted company, even if you are still relatively unknown, and will help you get a leg up on the competition.
Keep Good Records
If you know that you want to take out a construction loan in the near future, the best thing you can do to ensure the process goes smoothly is to keep good records and communicate regularly with your potential lenders. This way, you will ensure that all of your financial statements and other paperwork will be ready to go and that there will be no surprises when you are finally ready to get that loan.
Starting a new business is a brave venture and it can be successful with or without new construction. Securing financing options for new construction when a business is just beginning operations can be very tough, but it’s not impossible. For newer business owners, it may make more sense to take the time to build your business’s credibility while leasing office space. As always, when making a decision about finances, it’s best to review your business plan and goals with your trusted financial advisor.