Construction loan draws, guarantees and repayment

Why construction debt is structurally different from every other CRE loan

A stabilized perm loan funds once and pays interest on the full balance from day one. A construction loan funds incrementally, sometimes 12 to 30 monthly draws over 18 to 36 months, with the balance growing as work is completed. Every draw is a mini-credit-event that requires lender inspector sign-off, lien-waiver exchange, and validation against the AIA G702/G703 application for payment.

The operational intensity is not optional. Lender inspector visits, lien-waiver tracking, certified payroll on Davis-Bacon deals, stored-materials documentation, and change-order processing each demand sponsor and GC bandwidth. A sponsor with thin staffing and a first-time construction GC typically experiences delays at every monthly draw cycle, delays that compound into schedule slip and budget pressure.

Three layers of guaranty exposure (completion, carry, and the standard non-recourse carve-outs) typically remain in place through substantial completion and into the lease-up period. Burn-off mechanics control how long the personal exposure lasts.

Step 1: design the draw schedule before closing

The draw schedule is not a closing secondary item. It is the operating contract between sponsor, GC, and lender for the next 24 months. The line-item structure should mirror the GC's schedule of values exactly: every line in the loan budget should match a line in the GC contract.

Standard institutional pattern: hard costs fund monthly in arrears against AIA G702/G703 with lender-inspector validation; soft costs fund against actual invoices on the same monthly cycle; retainage held back at 10% of each hard-cost line; the lender inspector visits the site before each monthly draw to validate percent-complete claims.

Sponsor-friendly tweaks worth negotiating at term sheet: stepped retainage (10% on first 50% of work, stepping to 5% on second 50%); soft-cost reserve pre-funded at closing rather than monthly draws; off-site stored-materials funding at bonded suppliers; quarterly rather than monthly inspector visits during defined low-risk periods.

Step 2: lien waivers and the four-form mechanic

Most state mechanic's lien statutes recognize four waiver forms: conditional progress, unconditional progress, conditional final, and unconditional final. The four-form structure handles the timing gap between work being billed and payment actually arriving in the contractor's account.

Each draw cycle: GC and major subs deliver conditional progress waivers covering the current draw amount; lender inspector reviews and lender funds; with the next month's draw, the same parties deliver unconditional progress waivers for the prior period (now-paid) plus new conditional waivers for the current period.

Final waivers (conditional and unconditional) attach to the final draw at substantial completion. The unconditional final waivers from the GC and all known subs is the cleanest evidence of lien-free completion and is required before construction-to-perm conversion or before the takeout funds.

Step 3: change orders, contingency burn, and the balancing test

Change orders are inevitable. The question is whether the contingency reserve absorbs them or whether the sponsor has to fund overruns with new equity. Standard institutional contingency: 5% of hard costs for ground-up multifamily with experienced GCs; 7% to 8% for retail or hospitality; 10%+ for adaptive reuse and complex sites.

The balancing test is the lender mechanic for protecting itself once contingency is exhausted. Most loan documents require the sponsor to fund overruns with new equity before the lender funds the next draw. Burning contingency faster than the project's percent complete is a leading indicator of a budget problem.

Practical sponsor management: track contingency burn against percent complete on a monthly basis. When contingency burn exceeds project percent complete by more than 100 to 200 bps, escalate the conversation with the GC immediately, value-engineer scope, accelerate long-lead items, or negotiate trade-by-trade savings before the next monthly draw inspection forces it.

Step 4: completion guaranty and carry guaranty burn-off

Completion guaranty: the guarantor agrees to fund cost overruns to deliver the project per plans. Burns off at substantial completion, typically defined as certificate of occupancy issued, AIA G704 (architect's certificate of substantial completion) delivered, lien-free completion certificate from the title company, and the lender inspector's sign-off.

Carry guaranty: the guarantor agrees to fund debt-service shortfalls during construction and lease-up. Burns off at stabilized DSCR (commonly 1.20x to 1.25x) maintained for three to six consecutive months. Sponsor-friendly terms calculate DSCR using projected take-out perm rate; lender drafts use construction-loan rate (which makes the test harder to hit).

Negotiation focus at term sheet: tighten the DSCR test (debt yield instead of DSCR is even more sponsor-friendly), shorten the consecutive-months requirement, and require the burn-off to occur automatically upon meeting the test rather than requiring lender consent.

Step 5: HVCRE exemption mechanics

Federal banking regulators apply a 150% risk-weight to high-volatility CRE construction loans (HVCRE) versus 100% for routine CRE. The HVCRE-ADC exemption is the route to bank construction debt at attractive terms.

Three tests at origination and through life of loan: (1) regulatory LTV at or below the maximum for the property type (currently 80% multifamily, 75% commercial); (2) at least 15% contributed cash equity (or land contributed at lower of cost or appraised value) before any loan funding; (3) life-of-loan retention of contributed capital, no mid-construction distributions of contributed capital.

Step 6. Davis-Bacon and prevailing wage on covered projects

Davis-Bacon attaches to construction projects funded with federal money, most commonly HUD-insured construction loans (Section 221(d)(4)) and projects with LIHTC, HOME, or CDBG funding. Prevailing-wage compliance typically adds 10% to 25% to hard costs in open-shop markets, less in markets where prevailing wages closely track union scales.

Compliance overhead is meaningful: weekly certified payrolls submitted to the DOL through the WHD-347 process, labor classifications matched to county wage determinations, and compliance reviews by the lender (HUD on a 221(d)(4) deal) and any other federal funder.

Underwriting move: include the prevailing-wage premium in the cost basis at term-sheet stage. A pro forma that does not adjust for prevailing wage on a HUD deal will be 10% to 25% under-budgeted on labor, a problem that surfaces during architect re-pricing or first-draw under-funding.

Step 7, takeout structures: construction-to-perm vs. mini-perm vs. two-close

Construction-to-perm (single close): one loan with conversion mechanics from construction-period floating to permanent fixed at a defined trigger. Strengths: one closing, no re-underwriting risk. Constraints: not all lenders offer; perm-period rate set early.

Mini-perm: construction loan extends 12 to 36 months at construction-period pricing while the sponsor stabilizes for permanent takeout. Strengths: no second closing during unstable lease-up; relationship continuity; rate-environment timing flexibility. Constraints: construction-loan-style pricing through the mini-perm period.

Two-close: construction loan pays off at stabilization with proceeds from a separately-placed perm loan from a different lender. Strengths: full lender competition for perm; pricing reflects stabilized property. Constraints: re-underwriting risk; appraisal and rate exposure between maturity and perm closing.

Step 8: assemble the deal team before construction starts

The construction-period team is larger than a perm-loan team. Sponsor PM, construction lender's relationship officer, lender inspector, GC PM, GC accounting, architect, MEP engineer, environmental consultant, title company (for date-down endorsements at each draw), borrower's counsel, lender's counsel, and on Davis-Bacon deals a labor-compliance consultant.

Coordination is the placement firm's job through closing and the sponsor's job after closing. A weekly draw coordination call (sponsor, GC, lender) eliminates 90% of friction at draw time.

Frequently asked questions