Commercial Construction Loans: Rates, Terms & How They Work

What Is a Commercial Construction Loan?

A commercial construction loan is short-term financing used to fund the construction of a new commercial property or a major renovation of an existing one. Unlike permanent commercial mortgages that finance completed, income-producing properties, construction loans finance a project that does not yet exist -- which makes them fundamentally different in structure, risk profile, and underwriting approach.

Construction loans are typically 12 to 36 months in duration, carry higher interest rates than permanent financing, and disburse funds incrementally through a draw schedule as construction milestones are completed. Upon project completion, the construction loan is either repaid through a separate permanent loan (two-close structure) or converts into permanent financing (construction-to-perm or single-close structure).

How Construction Loans Differ from Permanent Financing

The key risk for construction lenders is that the collateral is being created during the loan term. If the project stalls, costs overrun, or the borrower defaults mid-construction, the lender holds a lien on a partially completed building -- which has significantly less value than the completed project. This risk premium is reflected in higher rates and stricter qualification requirements.

Current Commercial Construction Loan Rates (May 2026)

Construction loan rates vary significantly by project type, borrower experience, market location, and loan-to-cost ratio. The table below reflects current market ranges based on data from FRED benchmark rates and lender surveys:

Rate note: Rates are quoted as interest-only during the construction period. The effective cost is lower than it appears because interest accrues only on the drawn balance, not the full commitment. In a typical 18-month construction project, the average outstanding balance may be only 50-60% of the total loan amount. For current rate benchmarks across all commercial loan types, visit our rates page.

The Draw Schedule

Construction loans do not fund all at once. Money is released through a draw schedule -- a structured sequence of disbursements tied to construction milestones or percentage completion.

How Draws Work

1. Borrower completes a phase of work (e.g., foundation, framing, rough electrical)
2. Borrower submits a draw request with documentation (invoices, lien waivers, progress photos)
3. Lender orders an inspection by a third-party inspector who verifies work completion
4. Lender releases funds for the completed work, typically within 5-10 business days after inspection

Typical Draw Schedule for Ground-Up Construction

Retainage: Lenders typically hold back 5-10% of each draw as retainage (also called retention). This retainage is released only after the project achieves substantial completion, the certificate of occupancy is issued, and all lien waivers are collected. Retainage protects the lender against contractor non-performance and mechanic's liens.

Interest-Only Period

During construction, borrowers pay interest only on the amount drawn -- not on the full loan commitment. This significantly reduces the cash burden during the construction period when the property is not generating income.

Example: On a $5M construction loan at 8%:

• Month 1 (after first $500K draw): Interest = $500,000 x 8% / 12 = $3,333/month
• Month 6 (after $2.5M drawn): Interest = $2,500,000 x 8% / 12 = $16,667/month
• Month 12 (fully drawn $5M): Interest = $5,000,000 x 8% / 12 = $33,333/month

Some lenders offer an interest reserve -- a portion of the loan commitment set aside to pay interest during construction so the borrower does not need to make monthly payments out of pocket. The interest reserve is included in the total loan amount and increases the effective borrowing cost.

Construction-to-Permanent Conversion

When the construction project is complete, the borrower needs permanent financing. There are two approaches:

Two-Close Structure

The borrower obtains a separate permanent loan (the "takeout") from potentially a different lender. Two separate closings, two sets of closing costs.

Pros: Borrower can shop for the best permanent rates at completion; not locked in to construction lender's terms. Cons: Two sets of closing costs ($20K-$50K+ each for commercial loans); risk that permanent financing is not available at completion (rate changes, property underperformance); requires a takeout commitment letter before most construction lenders will fund.

Single-Close (Construction-to-Perm)

The construction loan automatically converts to a permanent loan upon completion. One closing, one set of closing costs, guaranteed takeout.

Pros: One closing saves significant costs; eliminates takeout risk; rate for permanent phase can be locked or capped at origination. Cons: Potentially less favorable permanent terms than shopping at completion; locked in to one lender for both phases. Which to choose: For borrowers who want certainty and cost savings, single-close is usually preferred. For experienced developers with strong banking relationships who want maximum flexibility, the two-close structure allows optimization at each stage.

Lender Requirements for Construction Loans

Construction lenders impose stricter requirements than permanent lenders due to the higher risk profile:

Borrower Qualifications

### Project Qualifications

• Fixed-price general contractor (GC) contract -- lenders require a GC agreement with a guaranteed maximum price (GMP) or fixed-price contract. Cost-plus contracts are difficult to finance.
• Permits and entitlements -- all required building permits, zoning approvals, and environmental clearances must be obtained or conditionally approved before closing.
• Plans and specifications -- complete architectural and engineering drawings, stamped by licensed professionals.
• Budget with contingency -- detailed line-item budget with a 5-10% contingency reserve for cost overruns.
• Pre-leasing or pre-sales (for speculative projects) -- lenders may require 30-50% pre-leasing for office/retail or 30-50% pre-sales for condominiums before funding.
• Appraisal -- "as completed" and "as stabilized" values. The loan is sized on the lower of loan-to-cost (LTC) or loan-to-value (LTV, based on as-completed value).

Use our DSCR calculator to model the projected debt service once the property is stabilized and generating income.

Common Pitfalls in Construction Financing

Cost Overruns

The number one risk in construction lending. Material price increases, labor shortages, weather delays, and change orders can push costs 10-20% above budget. Lenders require contingency reserves, but if overruns exceed the contingency, the borrower must inject additional equity. Mitigation: Use a fixed-price GC contract, build adequate contingency (10% for new construction, 15-20% for renovation), and have a reserve fund beyond the lender's requirement.

Timeline Delays

Every month of delay adds interest expense, extends the interest-only period, and pushes back revenue generation. A 6-month delay on a $5M loan at 8% adds approximately $200K in additional interest. Mitigation: Use an experienced GC with a track record of on-time completion, build schedule contingency, and monitor progress weekly.

Takeout Risk (Two-Close Structure)

If permanent financing is not secured by the time construction is complete, the borrower faces costly loan extensions or default. Interest rate changes, property performance below projections, or lender market pullbacks can jeopardize the takeout. Mitigation: Secure a takeout commitment before or concurrent with the construction close, or use a single-close structure.

Mechanic's Liens

Unpaid subcontractors or material suppliers can file mechanic's liens against the property, clouding title and delaying permanent financing. Mitigation: Collect lien waivers from all subcontractors and suppliers at each draw, and verify that the GC is paying subs promptly.

Permit and Entitlement Issues

Unexpected permit conditions, zoning challenges, or environmental issues discovered during construction can halt work and create cost overruns. Mitigation: Complete all due diligence before closing, engage experienced land use counsel, and budget for potential environmental remediation.

Frequently Asked Questions

What is the minimum down payment for a commercial construction loan?

Most commercial construction lenders require 20-35% equity (meaning a loan-to-cost ratio of 65-80%). The exact requirement depends on the project type, borrower experience, and pre-leasing status. SBA 504 construction loans can offer a combined structure requiring as little as 10-15% borrower equity with the CDC second position. Ground-up speculative projects without pre-leasing typically require 30-40% equity.

Can I use land I already own as part of my equity?

Yes. Land equity is typically credited toward the borrower's required equity injection at its appraised value (not purchase price, unless purchased recently). If you own land free and clear valued at $500K and need $1M in equity for a $5M project, the land satisfies 50% of your equity requirement.

How are construction loan interest payments calculated?

Interest accrues only on the outstanding drawn balance, not the full loan commitment. Interest is calculated daily (annual rate / 365 x outstanding balance) and typically billed monthly. Some loans include an interest reserve funded from the loan proceeds so the borrower does not make monthly payments out of pocket during construction.

What is a completion guarantee?

A completion guarantee (or completion bond) is a commitment, usually from the borrower/guarantor, to complete the project even if costs exceed the budget. It protects the lender from being left with a partially constructed building. Most commercial construction loans require a completion guarantee as a standard condition. In some cases, a surety bond from the general contractor may substitute.

Can I get a construction loan for renovation of an existing property?

Yes. Renovation and rehabilitation projects are commonly financed with construction loans, though they are often structured as bridge loans with renovation draw schedules. LTC ratios may be higher (up to 80-85%) because the existing building provides baseline collateral. The lender will appraise both the "as-is" and "as-renovated" values to size the loan.

What happens if I cannot complete the construction project?

If a borrower defaults during construction, the lender typically has the right to: (1) call the full loan due, (2) take possession of the property through foreclosure, and (3) pursue the personal guarantee for any deficiency. The lender may also step in to complete the project using the remaining loan proceeds and the contingency reserve. Partially completed buildings sell at steep discounts (often 30-50% of completed value), which is why lenders require strong personal guarantees and completion assurances.