Residential Construction Loans: Underwriting Guidelines and Loan Documentation

Residential Construction Loans: Underwriting Guidelines and Loan Documentation

Over the last several years the thickness of an average loan file has grown from being measured in millimeters to inches. This is especially true for residential construction loans. 

Are you a loan officer, compliance officer, internal auditor, or involved in loan operations and production?

Over the last several years the thickness of an average loan file has grown from being measured in millimeters to inches. This is especially true for residential construction loans. The information below is directly from Dawn Kincaid's recent presentation for the Community Bankers Webinar Network, covering construction loan underwriting guidelines and residential construction loan documentation. 

Underwriting Guidelines

Proper Loan-to-Value Calculations for Construction Loans

Examiners have identified that some Lenders involved in construction lending are not adhering to prudent standards when calculating loan-to-value ratios. Their recommendations are:

“For properties where improvements are to be constructed or rehabilitated, an institution may request a prospective market value upon completion and a prospective market value upon stabilization. While an institution may request the appraiser to provide the sum of retail sales for a proposed development, the result of such calculation is not the market value of the property for purposes of the Agencies' appraisal regulations.

Appraisers are to analyze and report appropriate deductions and discounts for proposed construction or renovation, partially leased buildings, non-market lease terms, and tract developments with unsold units. For such transactions, an appraisal must include the market value of the property, which should reflect the property's actual physical condition, use, and zoning designation (referred to as the "as is" value of the property), as of the effective date of the appraisal. Therefore, if the highest and best use of the property is for development to a different use, the cost of demolition and site preparation should be considered in the analysis.”

This value is often referred to as the prospective value to one purchaser. Although appraisers typically provide both of these values in appraisal reports, some Lenders are incorrectly using the sum of retail sales when underwriting the loan and calculating the loan-to-value ratio. This results in two primary regulatory concerns

  • The collateral protection on the loan is overstated, as the sum of retail sales results in a higher value than the value to one purchaser. Furthermore, loan presentations, which are often used by the Lender’s Board of Directors or Loan Committee to decide whether to approve the credit, contain the incorrect loan-to-value calculation.
  • Loans that exceed loan-to-value guidelines may not be properly identified by the Lender. It’s important to develop specific monitoring requirements, including a limitation on the aggregate dollar amount of exception loans relative to the institution’s capital. By using the incorrect value from the appraisal, the Lender may be taking inappropriate risks.

For those institutions that have higher concentrations in construction lending, the significance of these issues is clearly magnified. Lenders are strongly encouraged to review the Interagency Appraisal and Evaluation Guidelines and ensure that policies and practices are appropriately established. Additional appraisal information including USPAP (Uniform Standards of Professional Appraisal Practice) standards can be found at


  1. Standard: 12 months interest only; then amortization. 
  2. 18 months or less, may be extended to cover time to market and sell. 
  3. 24 months is the maximum length of time a newly constructed single-family residence can be carried on an interest-only basis from the inception of the construction loan.
  4. After 24 months, the loan should be reduced to 80% of the then-market value and placed on a systematic amortization program (with one-year maturities) over a period not to exceed 30 years. Principal plus interest should be paid monthly.

Collateral: First lien on the property, with the lien insured by a title policy or construction binder issued by a title insurance company or an attorney’s opinion acceptable to the Lender. 

Rate & Fees: __________% Inspection fee of $______ for up to five inspections. Inspections exceeding 5 times is usually charged at a rate of $XX to $XX for each inspection.

Residential Construction Loan Documentation

Construction Lending documentation files should include:
  1. Financial and background information: to substantiate the expertise and financial strength of the borrower to complete the project.
  2. The Construction Loan Agreement: Sets forth the rights and obligations of the lender and borrower, conditions for advancing funds, and events of default. In some states, the agreement must be cited in either the deed of trust or mortgage.
  3. Recorded Mortgage or Deed of Trust
  4. Title Insurance Binder or Policy: Policy should be updated with each advance of funds if such additional protection is available. 
  5. Insurance Policies and Proof of Premium Payment: Evidence that the builder has adequate and enforceable coverage, including liability, fire, builder’s special risks, and where appropriate, flood insurance. 
  6. Appraisal or Evaluation 
  7. Project Plans, Feasibility Study, and Construction Budget 
  8. Property Surveys, Easements, and Soil Reports. While soil testing is more common for commercial properties, it may be warranted for single-family properties if construction includes a well or a leach/septic system. Costs for soil testing are considerably more expensive “pre-dig” versus “post-dig”; however, the cost for cleaning up contaminated soil or not being able to have proper drainage would be significantly more. Many municipalities require a soil test before awarding building permits. 
  9. Architect’s certification of the plan’s compliance with all applicable building codes, zoning, environmental protection, and other government regulations, as well as an engineer’s report on compliance with building codes and standards. 
  10. Take-Out Commitment, if any, from a permanent lender and the terms of the loan. The documentation files should indicate that the Lender verified the financial ability of the permanent lender to fund the take-out commitment and reviewed the take-out agreement to determine the circumstances in which it could be voided. 
  11. Completion or Performance Bond, written by an insurance company. 
  12. Evidence that property taxes have been paid to date. 
  13. Any environmental surveys deemed necessary given the location and type of project.

Construction Loan Checklist

Dawn Kincaid provides a residential construction loan checklist in her webinar, Construction Loan Nuts & Bolts: Documentation, Sample Scenarios & Avoiding Errors. Her detailed nuts-and-bolts webinar traverses the construction loan process, employs sample scenarios, reveals best practices, and exposes compliance potholes. Get specifics on:

  • Underwriting the borrower, commercial construction loans, and the builder/developer
  • Construction loan risks
  • Documenting commercial construction loans
  • TRID for construction loans and disclosures
  • Full appraisals vs. evaluations
  • Flood insurance
  • The Disbursement Process
  • Compliance Standards
  • And more

Plus a helpful toolkit that includes:

  • Sample inspection request form
  • Sample construction loan file checklist
  • Sample commercial real estate file checklist