In the construction industry, smooth cash flow is the key to ensuring that projects run seamlessly. For small business owners, understanding and accessing the right financing options is essential to maintaining a healthy balance sheet so that projects don’t grind to a halt. But who has time during their business day to be thinking financing their business when they are busy running it. To help make it easier, here’s a look into the various financing solutions available to construction businesses.
Understanding Construction Loans: A Crucial Financing Option
A construction loan is a short-term loan used to finance the cost of building a new construction. It is different from a traditional term loan since the lender pays out the loan amounts in stages based on the progress of the construction project. These loans typically have a term ranging from 6 to 24 months.
Loan to Value Ratio: What Does It Mean?
The loan to value ratio is a vital metric that lenders use to determine the risk associated with the construction loan. A lower ratio means the borrower has made a higher down payment, reducing the lender’s risk. It is calculated by dividing the loan amount by the total value of the property or project.
The Loan to Value (LTV) ratio holds significant importance to owners of construction companies for several reasons:
- Access to Financing: For construction business owners, securing adequate financing is critical to keep projects moving forward. Understanding their LTV ratio helps these owners know how much lenders are willing to finance. A favorable LTV ratio can facilitate easier access to necessary funding.
- Risk Management: A lower LTV indicates that the construction company owner has more equity or investment in the project, reducing financial risk. It’s a sign that they have more “skin in the game,” which can enhance confidence among lenders, suppliers, and other stakeholders.
- Interest Rates and Loan Terms: Lenders often base the terms of a construction loan, including interest rates, on the perceived risk associated with it. A better LTV ratio can lead to more favorable loan terms, which can have a substantial impact on the cost of a project.
- Equity Evaluation: For construction company owners, understanding the LTV ratio can provide insights into their equity position in a given project. This is crucial when considering further leveraging, selling, or expanding the project.
- Cash Flow Management: Projects with a high LTV may require higher monthly payments, impacting the company’s cash flow. By understanding and managing the LTV, construction company owners can better anticipate and manage monthly financial obligations.
- Negotiation Leverage: When discussing terms with lenders, subcontractors, or other partners, having a favorable LTV can be used as a point of negotiation, indicating the financial strength and stability of the project.
- Future Financing Decisions: As construction companies often handle multiple projects simultaneously or consecutively, understanding the LTV ratios across different ventures helps owners make informed decisions about where to allocate resources and how to prioritize future financing needs.
The Builder Cash Flow Loan
A developer who wishes to temporarily finance construction costs could also consider a builder cash flow loan. Unlike traditional construction loans, a builder cash flow loan provides upfront cash based on the projected cash flow of the completed project. This type of loan is beneficial for developers because it offers immediate funds to meet the construction business’s current needs.
Hard Money Loans
A hard money loan is a short-term, asset-backed loan where the borrower receives funds secured by real estate. These loans are typically issued by private investors or companies and come with higher interest rates. The eligibility is often based on the property’s value rather than the borrower’s credit history. This makes it an option for construction business owners who might have bad credit but have valuable real estate assets.
However, for businesses with poor credit scores, a merchant cash advance is likely the better financing solution. MCAs are gaining traction among small business owners because they provide upfront working capital in exchange for a percentage of future sales. This ensures that repayment terms* are in line with the business’s revenue flow, making it an attractive option for those in the construction industry where cash flow can be unpredictable.
The SBA Loan for Construction Business Loans
Another option is construction financing through the Small Business Administration (SBA) offers various small business loan programs designed to cater to the unique business needs of general contractors and construction companies. SBA loans may come with competitive interest rates and longer repayment terms. However, the application process can be much lengthier, and eligibility requirements stricter, so it’s crucial to weigh the pros and cons.
Exploring Other Funding Options for the Construction Business
While we’ve delved into some of the more popular financing solutions, it’s worth noting that there are numerous other funding options available:
- Online Lenders: For construction business owners seeking quick funding without the extended application process, online lenders can be a viable choice.
- Invoice Factoring: This involves selling your unpaid invoices to a third party at a discount to get immediate cash.
- Credit Unions: These member-owned financial institutions often offer competitive loan options tailored for small businesses.
Construction business owners have a plethora of financing options to choose from. The key is to assess your business’s needs and financial health and then choose the most fitting solution. With flexible financing solutions within reach, the construction industry’s future remains promising for both new and seasoned business owners.
*Repayment in this context describes the process of repurchasing a merchant cash advance. It does not describe the process of repaying a loan. MCAs are legally distinct from loan products.