Construction loan is short-term commercial real estate debt, typically 12 to 36 months, that funds ground-up development or major renovation. It is disbursed in draws against documented work in place rather than as a lump sum, carries a floating interest-only rate, and is repaid by a permanent loan or a sale once the project is complete and stabilized.
How Does a Construction Loan Work?
A construction loan works by advancing funds in stages as the project is built, not at closing. The lender approves a schedule of values, then releases each draw against verified work in place, usually confirmed by a third-party inspector. The balance grows over time, so interest accrues only on funds actually drawn, and repayment comes from a takeout loan or sale.
Per Terrapin Capital Group and Conventus, a commercial construction loan commonly runs 12 to 36 months and funds in monthly draws against an approved schedule of values. At closing the lender typically disburses an initial draw and funds an interest reserve, an account set aside to cover 12 to 18 months of estimated interest during construction, since the project produces no income to service debt.
Term | Representative range (2026) |
Loan term | 12 to 36 months |
Loan-to-cost | 55% to 75% of total project cost |
Interest rate | Roughly 7.3% to 9.25% (banks), higher for private lenders |
Payment type | Interest-only, often paid from an interest reserve |
Disbursement | Monthly draws against a schedule of values |
Per Terrapin Capital Group, loan-to-cost in 2026 generally runs 60% to 75%, with industrial and build-to-suit at the high end and speculative office or hospitality at the low end. Because the lender funds the interest reserve out of the loan and includes it in the total development budget, that reserve is itself part of the loan-to-cost calculation, which is why true loan-to-cost is easy to understate.
Why Construction Loans Matter
Construction loans matter because development produces no income until the building is complete, so a project cannot support conventional debt sized to cash flow. The loan funds the gap between an empty site and a stabilized asset. Its draw structure and interest reserve exist precisely because there is no rent to service interest during the build.
Per Buildermuse, commercial construction loan rates averaged 8.4% in 2026, a level not seen since before the Great Recession, which makes carry cost a real driver of feasibility. A project that pencils at a 7% rate can fail at 9%, because interest accrues on a rising balance for the full build period. The draw structure limits that cost by charging interest only on funds already advanced.
The quotable point for an operator: a construction loan is priced on a balance that grows every month, so the carry cost is a function of the draw schedule, not the full loan amount.
Example
A developer builds a warehouse with a total project cost of $10,000,000. A lender offers 70% loan-to-cost, a $7,000,000 loan, at an 8.5% interest-only floating rate over a 24-month term. Funds are drawn monthly against a schedule of values, so interest accrues on the average outstanding balance, not the full amount.
Item | Calculation | Result |
Total project cost | Given | $10,000,000 |
Loan-to-cost | Given | 70% |
Loan amount | 70% x $10,000,000 | $7,000,000 |
Full-balance annual interest | 8.5% x $7,000,000 | $595,000 |
Approximate carry (50% average balance, 24 months) | $595,000 x 0.5 x 2 | $595,000 |
Because draws ramp up over the build, the average outstanding balance across a 24-month construction period is roughly half the final loan amount. Interest at 8.5% on that average balance over two years is about $595,000, funded from an interest reserve inside the $7,000,000 loan. Had the developer paid interest on the full $7,000,000 for both years, carry would have been $1,190,000, so the draw structure roughly halves the true cost.
Variations and Edge Cases
Construction loans are not uniform: leverage, disbursement, and structure shift with the sponsor, the asset, and the completion risk. The table below covers the variants an operator should confirm before signing a term sheet.
Variant | Treatment |
Loan-to-cost vs loan-to-value | Leverage may be sized on total cost or on completed value, which changes proceeds |
Interest reserve | Funded inside the loan; if it runs out, the sponsor covers interest out of pocket |
Retainage | Lenders hold back 5% to 10% of each draw until completion to ensure the job finishes |
Construction-to-permanent | A single loan that converts to permanent debt at completion, avoiding a second closing |
Completion guaranty | Many loans require a sponsor guaranty that the project is finished on budget |
The most common mistake is undersizing the interest reserve. If rates float higher or the build runs long, the reserve depletes before completion, and the sponsor must fund interest out of pocket at the worst possible moment. The reserve should be stress-tested against a higher rate and a delayed timeline before the loan closes.
Construction Loan vs Bridge Loan
Construction loan is often confused with a bridge loan, and both are short-term and interest-only, but they finance different situations. A construction loan funds ground-up development or major renovation and disburses in draws as the building rises. A bridge loan funds an existing, standing property in transition, such as one being leased up or repositioned, and usually advances in a lump sum.
The practical difference is what exists at closing. A construction lender funds a project with no building yet and controls disbursement through draws and inspections to manage completion risk. A bridge lender funds a property that already stands and underwrites its as-is value and business plan. Both are refinanced into a permanent loan at exit.
Frequently Asked Questions
What is a construction loan in commercial real estate?A construction loan in commercial real estate is short-term debt, typically 12 to 36 months, that funds ground-up development or major renovation. It is disbursed in draws against documented work in place, carries a floating interest-only rate, and is repaid by a permanent loan or sale once the project is complete.
What loan-to-cost do construction lenders offer?Construction lenders in 2026 typically offer 60% to 75% loan-to-cost, per Terrapin Capital Group. Industrial and build-to-suit projects reach the high end, while speculative office and hospitality fall to 55% to 65%. Tighter lending standards have pushed many deals toward the lower end of that range.
What is an interest reserve on a construction loan?An interest reserve is a portion of the construction loan set aside at closing to cover monthly interest during the build, often 12 to 18 months of estimated interest. It exists because a project under construction produces no income to service debt. If it depletes, the sponsor pays interest out of pocket.
How is interest charged on a construction loan?Interest on a construction loan is charged only on funds actually drawn, not the full loan amount. Because draws ramp up as the building rises, the average outstanding balance over the term is often near half the final loan, which lowers true carry cost relative to a fully funded loan.
Related Terms
Loan to Value Ratio
Bridge Loan
Permanent Loan
Development Spread
Yield on Cost