- Construction loans are sized on Loan-to-Cost (LTC), not LTV — typically 65–75% of total project cost.
- Funds are disbursed in draws, not as a lump sum, based on verified construction progress.
- A 10% retainage holdback protects lenders until substantial completion.
- Contingency reserves (5–10% of hard costs) are required — borrowers who skip them almost always regret it.
- Interest is typically charged only on the drawn balance, which reduces early-stage carry costs.
Construction loan financing is fundamentally different from permanent mortgage debt. The lender isn't financing a completed, income-producing asset — they're financing the creation of one. That distinction drives every structural feature of a construction loan: how it's sized, how it's drawn, and how the lender protects itself against the very real risk that the project goes sideways.
LTC vs. LTV: Why Construction Lenders Think Differently
A permanent lender sizes its loan against the property's current appraised value (LTV). A construction lender sizes against total project cost (LTC) because no income-producing asset exists yet to appraise. Total project cost includes land acquisition, hard construction costs, soft costs (architecture, engineering, permits, legal), financing costs, and the developer's fee.
Most institutional construction lenders advance 65–75% of total project cost. The remaining 25–35% is developer equity, which must typically be contributed first — lenders insist on "equity in first" to ensure the developer has maximum skin in the game before the lender funds a dollar.
How Construction Draws Work
Rather than releasing all loan proceeds at closing, construction lenders disburse funds in monthly draws that correspond to verified construction progress. The process works like this: the developer submits a draw request with lien waivers, invoices, and a schedule-of-values update showing completed work. An independent construction monitor (hired by the lender) inspects the site, confirms the work is in place, and approves the draw amount. The lender then wires funds directly — often to a joint-control account that requires both borrower and lender signatures for disbursement.
A 10% retainage is typically withheld from each draw and released only upon substantial completion. This protects the lender against the final stages of a project being left incomplete.
Risk Buffers Every Construction Lender Requires
Contingency reserve: 5–10% of hard costs is held in reserve for unforeseen conditions. In 2025–2026 this is non-negotiable — supply chain volatility and labor shortages mean cost overruns are the norm, not the exception. Lenders that waive contingency requirements are lending on optimism, not risk management.
Interest reserve: Funded at closing and held by the lender, the interest reserve covers projected interest payments during the construction period. Because the loan draws down over time (and interest accrues only on the drawn balance), the reserve is sized on a month-by-month projection of expected draws. A 24-month construction project might carry a 22-month interest reserve, assuming draws accelerate in the final quarter.
Completion guarantee: Most construction lenders require a personal completion guarantee from the developer — not just the project entity. If the project runs out of money, the guarantor must fund cost overruns to completion. This is the most significant personal obligation in a construction loan.
Construction-to-Permanent: The Mini-Perm Option
Some lenders offer a combined construction-to-permanent (C2P) loan that converts automatically to a permanent mortgage upon project completion. The borrower avoids a separate takeout refinancing event — reducing closing costs, rate risk, and the execution risk of finding a permanent lender in a potentially changed market. SBA 504 and USDA B&I both offer C2P structures that are particularly effective for hotel and assisted living development in the Southeast.
Case Study: 80-Room Hotel Ground-Up, Murfreesboro TN
Total project cost: $11.2M (land $1.4M, hard costs $8.1M, soft costs $1.1M, financing $0.6M). Construction loan: $7.8M (69.6% LTC) at SOFR + 375 bps (all-in 8.2%), 18-month term with a 6-month extension option. The interest reserve funded $820K at closing. The developer contributed $3.4M equity first. Draws ran monthly over 16 months; retainage released at month 17. The project converted to a $7.2M CMBS permanent loan at 6.75% upon certificate of occupancy.
What is a reasonable contingency reserve for a commercial construction project in 2026?
Most lenders require a contingency reserve of 5–10% of hard construction costs. Given ongoing labor and materials cost volatility, 7–10% is prudent for projects starting in 2025–2026. Some lenders set the contingency higher for hospitality projects (which involve complex FF&E coordination) or coastal projects subject to hurricane-resistant building codes.
First Realty Capital structures construction-to-permanent financing for hotels, multifamily, and assisted living across the Southeast. Request a preliminary construction loan analysis.
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