When you, as a real estate investor or rehabber, take out a construction or rehab loan, you are probably going to come across the phrase: Draws taken in arrears of construction.
I think this needs some elaboration, because I think this is one of those phrases that says a lot in a few words. Borrowers may not understand all the implications and how it will effect their transaction. Sort of like “Time is of the essence.” Sounds innocuous enough, but has a huge impact if you don’t get it.
First, let’s outline a scenario. You are buying a property in disrepair to fix up and resell to an end buyer. You borrow from a bank (unlikely these days) or a hard money lender (more likely these days) the funds to acquire and fix up the property. You probably had to put down a significant downpayment towards the purchase, and then you received the rest of the purchase money at closing, with the repair funds held for future disbursement. They are usually disbursed “in arrears of construction”.
So you close on the loan, and the next day you call your lender and the conversation goes something like this:
You: “I need a construction draw to purchase materials and start the rehab.”
Lender: “Sorry, your draws are in arrears, as outlined in the commitment and loan docs.” (Lender is thinking “Did you actually read anything I sent you?”)
You: “What do you mean? How can I start the project without money?” (You are thinking “Boy, I should have expected this loan shark to screw me over.”)
Now you are both in a bad position: You have a project you can’t start, and the lender has a borrower who can’t deliver as promised.
So here is what you need to know: “In arrears of construction” is exactly the opposite of “in advance of construction” – it happens after that portion of the construction is complete. Usually you will do a part of the job, then get reimbursed for that part of the construction after it happens. Then you do the next part of the job, and get reimbursed for that next part of the construction after it happens. The final draw is usually disbursed after the certificate of occupancy is issued, or whatever formality you get from the building inspector in your area. You will need to supply lien waivers from your subcontractors and copies of invoices/receipts and sometimes photos.
Usually a lender will inspect at each draw,or sometimes send an inspector.
This is not particular to hard money lenders, this is a process that happens everywhere in construction, both residential and commercial, if there is a construction loan involved.
Occasionally, if you paid actual cash for the property, the first draw can be disbursed when the construction loan is closed, because there is enough equity, and “skin in the game” to give the lender security for that first draw. But your second draw will be made after you have done the first part of the construction, and then some more, to bring you to where the lender is reimbursing you for construction already done, not advancing you funds to buy materials and labor before it happens.
And usually these draws are taken by line item. For example, if you have allocated $10,000 to electrical, and only the rough-in is complete, you will only be disbursed a portion of that $10,000. And so on for each line item.
Your application includes your rehab budget, and the draw worksheet. You input budget items and the dollars allocated for each item. Then as you request a draw, you input the amount of that item that is complete, and the spreadsheet shows the total of each draw request and the balance you have left to draw for that item. You can send this spreadsheet to the lender with your draw request, and it makes you look professional, and gives you both a common reference.