What the term sheet doesn't tell you about draw schedules, contractor problems, budget overruns, and the refinancing challenge at project completion.
Construction lending gets sold on its attractive features. You only pay interest on drawn funds. The loan converts to permanent financing when the project is complete. You maintain control of the construction process. These are legitimate features. They are also only part of the story.
The risks in construction lending are structural and layered. They don't appear in the term sheet. They appear when construction is underway and the difference between the plan and reality starts to show. Understanding those risks before you break ground is the only way to manage them effectively.
Every construction loan has a draw schedule that defines when the lender releases funds and how much. The draw schedule is negotiated at the time of the loan, and what it contains matters enormously for how the project runs.
Draw schedules that are based on overly optimistic timeline assumptions create cash flow gaps during construction. If the lender releases 30% of funds upon foundation completion, but your foundation phase costs 40% of the budget, you are covering 10% of foundation costs out of pocket before you can draw for the next phase. On a large project, these gaps can be significant.
Draw disbursements require inspector sign-off in most construction loans. The inspector must verify that the work claimed has been completed to the standards required. This is supposed to protect the lender from funding incomplete work. In practice, it also creates timing delays that affect the contractor's payment schedule. When contractors wait on draw disbursements to pay subcontractors, subcontractors slow their work. When subcontractors slow their work, milestone completion dates shift, which delays the next draw. The cycle compounds.
Borrowers who enter construction lending without closely reading the draw schedule mechanics, the inspection requirements, and the disbursement timing provisions are flying blind on one of the most operationally complex parts of the transaction.
The general contractor relationship is one of the highest risk factors in any construction project. A contractor who overcommits, runs into cash flow problems on other projects, loses key subcontractors, or simply proves to be less competent than their initial presentation suggested can slow, damage, or completely derail a construction project.
When a contractor stops performing, the consequences cascade rapidly. Work stops at whatever stage the project is in. Subcontractors who haven't been paid begin filing mechanic's liens against the property. The title becomes clouded, which creates problems for any future financing. The lender, upon learning of contractor default, may freeze further draws until the situation is resolved.
Finding a replacement contractor willing to take over a partially completed project is not straightforward. Contractors who evaluate a takeover situation must price in the risk of hidden defects in completed work, the cost of correcting any problems they find, and the complexity of assuming relationships with the existing subcontractors. Every one of those factors adds to the replacement cost relative to what the original contractor bid.
During all of this, the construction loan is accruing interest. The maturity date is not paused while contractor disputes are resolved. The financial clock keeps running even when physical construction has stopped.
This bears saying directly: construction budgets almost never come in on the original estimate. Materials prices change from the time the estimate is prepared to the time materials are purchased. Labor markets shift. Site conditions produce surprises. Code changes require adjustments. Inspectors require modifications that weren't in the original scope. Owner-driven design changes add cost that wasn't budgeted.
The construction industry standard for contingency is 10-15% of hard construction costs for an established project with a detailed scope, and 15-20% for projects with any complexity or site uncertainty. These are not pessimistic figures. They reflect what experienced developers have learned from running actual projects.
Borrowers who structure construction loans with inadequate contingency do so for understandable reasons. The lender requires a contingency line item. Reducing it reduces the total loan amount and therefore the required down payment. The pressure to minimize contingency is real. The risk of insufficient contingency is also real, and it shows up mid-project when there's no good way to address it.
When contingency is exhausted, the borrower faces a choice: contribute additional personal capital to complete the project, negotiate a loan modification with the lender for additional proceeds, or stop work. None of these options are pleasant, and the lender has no obligation to provide additional funds beyond the original loan commitment.
Permit timelines vary enormously by municipality, project type, and current permit office workload. In some markets, permits for complex projects take 12-18 months to obtain. Construction cannot begin without permits. If a construction loan is originated before permits are in hand, and permit approval takes longer than expected, the borrower begins paying construction loan interest while physically unable to begin the project.
Mid-construction inspections that reveal code compliance issues can require work stoppages and design modifications. A failing structural inspection may require removal and replacement of completed framing. A plumbing inspection that reveals improper installation requires correction before the inspector will pass the work and allow the next phase to proceed. Each of these events adds time and cost to a project where both are constrained.
A construction loan is not permanent financing. It matures when the project is complete or when the loan term expires, whichever comes first. At that point, the borrower must obtain permanent financing to pay off the construction loan.
This transition, called the take-out, is a separate underwriting event. The permanent lender will evaluate the completed property based on its current appraised value, the debt service coverage ratio if it's an income property, and the borrower's current financial condition. All three of these factors may have changed since the construction loan was originated.
If construction costs ran over budget, the borrower may have less equity than expected. If the market weakened during the construction period, the as-completed appraised value may be lower than projected. If interest rates rose, the borrower may not qualify for permanent financing at the same terms they planned. If personal income changed, the qualifying criteria may have shifted.
Borrowers who enter construction financing with a mental picture of seamlessly converting to a permanent mortgage sometimes find that picture doesn't survive contact with the market conditions that exist at project completion.
The safest approach is to obtain a take-out commitment from a permanent lender before the construction loan closes. A committed take-out lender removes the refinancing risk at the back end of the project. Not all construction loan situations allow for this, but when it's possible, it's worth pursuing.
Before signing a construction loan, a thorough review should cover the draw schedule and inspection requirements in detail, the lender's rights if construction falls behind schedule, the contingency reserve and how it can be accessed, the maturity date and what happens if the project runs long, and the take-out financing plan.
For a detailed breakdown of construction loan risks, see the construction loan risks guide from Coventry Enterprises LLC. If you have a construction loan you want reviewed before you sign, our consulting services provide independent analysis of your specific terms and structure.