Out-of-Pocket Expenses and the Construction Loan

            While working as the vice-president and onsite project manager for the construction of four high-end houses in Newport Coast in Southern California, the construction lender could not entirely cover the “hard-costs” for each of these houses having sales prices of $6.75 to $12.5 million (in year 2002). 

            The brick-and-mortar hard-costs for each house exceeded their loan limits.

            We therefore capitalized (owner’s equity) 18-1/2% of the upfront costs of the construction budget, paying out-of-pocket for the concrete work and part of the lumber costs. 

            The idea here is to postpone the disbursement of construction loan funds to a later point in time during the construction, so that the clock for loan interest costs begins part-way into the total project duration. 

            This meant that the construction loan did not start until roughly four months into the construction of each house, saving on loan interest costs reduced from the full 18-month construction schedule to 14 months.

            The suggestion here is that if some portion of the construction costs must be capitalized by the builder, from a loan interest cost-perspective it may be cheaper to fund the front-end of the project.

            I also worked for nine years as a construction manager for a bank. 

            Several savvy, single-family builders manipulated their construction disbursements to minimize loan interest payments. 

            Even though the construction budget lines itemized on the construction loan document have the required funds for each category of the work, the borrower is not required to withdraw/use these funds for every budget line-item during the course of the construction.

            Some borrowers would complete the construction and sell the new house, close escrow, and pay-off the loan, yet still have unused funds in several categories in the budget like HVAC, flooring, landscaping, supervision, and builder’s fee, for example.

            By not using all of the funds in the construction loan, these borrowers elected to save on loan interest costs by capitalizing some of the work out-of-pocket.

            The construction lender is required to adequately fund the new construction project by having all the budget line-items covered.  This banking requirement was regularly audited by a government agency, in our case the OTS (The Office of Thrift Supervision).

            But the borrower is not under any requirement to use all of the funds itemized in the loan budget. 

            Loan interest costs are calculated on the funds disbursed-to-date, and not on unused funds undisbursed in the loan.