🚧 Construction Cost Overruns: The #1 Risk That Can Kill Your Loan Approval 💰

🏗️ How Construction Budget Mistakes Destroy Financing (And How to Avoid It) ⚠️

Construction Cost Overruns & Financing Risk: What Borrowers Need to Know

“Most construction projects don’t fail because of the deal.
They fail because the budget was wrong.”

If you’re building, renovating, or developing real estate, construction cost overruns are one of the biggest financial risks you face—and lenders know it.

From a financing perspective, cost overruns aren’t just an inconvenience.
They can break your loan, kill your returns, and force you to bring more cash to the table.

Let’s break down how lenders view this risk—and how smart borrowers structure around it.

Why Construction Cost Overruns Are So Dangerous

In today’s environment—especially in markets like Houston—construction costs are volatile:

·Labor shortages

·Material price swings

·Permit delays

·Change orders mid-project

Even a 5–10% cost overrun can completely change your deal structure.

Here’s why:

👉 Your loan is based on a fixed budget (LTC)
👉 Your valuation is based on projected NOI
👉 Your exit depends on hitting those numbers

If costs go up but rents don’t?
Your entire capital stack gets squeezed.

How Lenders Underwrite Construction Risk

Lenders aren’t guessing—they’re underwriting downside.

Here’s what they focus on:

1. Loan-to-Cost (LTC)

Most construction loans sit around:

·60%–70% LTC

That means:

·You’re already bringing 30%–40% equity

·Any overrun? That’s on you

👉 Key Insight:
Cost overruns don’t get financed—they get funded by the borrower.

2. Contingency Reserves

Most lenders require:

·5%–10% contingency built into the budget

But here’s the reality:

➡️ That buffer disappears quickly with:

·Change orders

·Site issues

·Delays

If your contingency is thin, lenders see risk immediately.

3. Interest Reserves

Many construction loans include:

·3–12 months of interest reserves

But if your project is delayed:

·Reserves burn faster

·You may need to inject additional capital

4. Exit Risk (The Real Problem)

This is where most borrowers get it wrong.

If costs increase:

·Your basis goes up

·Your DSCR goes down

·Your refinance options shrink

👉 Lenders are asking:
“Can this deal refinance at today’s rates?”

If the answer is no—your deal is at risk before it even starts.

Real-World Example

Let’s break it down:

·Original project cost: $2,000,000

·Loan at 65% LTC: $1,300,000

·Equity: $700,000

Now add a 10% overrun ($200,000):

·New cost: $2,200,000

·Loan stays the same

·New equity required: $900,000

👉 That’s a 28% increase in equity required

And most borrowers aren’t prepared for that.

How Smart Borrowers Protect Themselves

This is where strategy separates amateurs from professionals.

1. Underwrite with Conservative Costs

·Inflate labor/material estimates slightly

·Assume delays

·Build real contingencies

👉 Don’t underwrite to “make the deal work”

2. Structure Liquidity Upfront

Lenders want to see:

·Post-closing liquidity

·Reserves available

👉 Liquidity = flexibility when things go wrong

3. Lock in Pricing Where Possible

·Fixed-price contracts

·Guaranteed maximum price (GMP) agreements

👉 This transfers risk away from you

4. Focus on Exit From Day One

Ask:

·What does DSCR look like at stabilization?

·What happens if rates stay higher?

·Can I refinance this loan safely?

👉 Structure beats rate—every time

5. Work with a Mortgage Broker

Most borrowers go to one bank.

Professionals:

·Shop multiple lenders

·Structure interest reserves

·Negotiate contingency requirements

·Align financing with the business plan

👉 That’s where deals get saved—or lost.

Final Takeaway

Construction cost overruns aren’t a “what if.”
They’re a when.

The real question is:

Did you structure your financing to survive it?

If you’re building, renovating, or developing—strategy matters more than ever.

📞 Call to Action

If you're buying, refinancing, or structuring a commercial deal in the next 12 months:

Let’s build the deal the right way — before it ever hits underwriting.

Bill Rapp
Medallion Funds

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© 2023-2024 Bill Rapp, Medallion Funds LLC, Director of Capital Advisory