Acquisition, Development, and Construction Loans

Written by: Heather Colvin

What is an Aquisition, Development, and Construction (ADC) Loan?

An ADC loan refers to a loan in which the lender participates in the expected residual profit from a real estate project. Features of a typical ADC loan include the following:

• The borrower has little or no investment in the project
• The lender provides the majority of the funds needed to acquire, develop, or build the project
• The lender funds most of the interest and fees during the loan term by adding them to the loan balance.
• The borrower is not required to make any loan payments until after completion of the project.
• The loan is only secured by the project itself.
• Repayment of loan depends on the sale of the property, refinancing of the loan, or cash flows from property operations after completion, assuming the project will generate sufficient cash flow to cover all scheduled debt payments.

The lender usually receives what is commonly referred to as an equity kicker. The equity kicker is usually a percentage of the operating profits and gain on sale, or it could be received in interest rates or fees that are higher than prevailing rates on similar loans.

How should the lender classify an ADC Loan?

There are three ways the lender can classify an ADC Loan. The first way is to treat it as a Direct Investment in Real Estate. The second way is to treat it as a Loan. The third way is to treat it as an Investment in a Real Estate Joint Venture. Below are conditions for each classification.

• The lender should classify the ADC Loan as a Direct Investment in Real Estate, if they will receive a majority of the project's expected residual profit. On top of the equity kicker, interest and fees above the prevailing rates should be included in the lender's profit.
• The lender should classify the ADC Loan as a Loan, if the lender will participate in less than a majority of the expected residual profit, plus at least one of the following conditions exists:
• The borrower has a substantial equity investment in the property that is not funded by the lender.
• The lender has recourse to a substantial amount of other assets of the borrower.
• The borrower has provided an irrevocable letter of credit from a creditworthy independent third-party to the lender for a substantial amount of the loan over the entire loan term.
• The borrower has a take-out commitment for the full amount of the loan from a creditworthy, independent financial institution.
• Noncancelable sales contracts or lease commitments from creditworthy, independent third-parties currently exist, which will provide sufficient cash flow upon completion of the project to cover normal principal and interest payments.
• The lender has obtained qualifying personal guarantees from principals or borrowers.
• The lender should classify the ADC Loan as an Investment in a Real Estate Joint Venture, if the above conditions for classification as a Direct Investment or a Loan are not met.

PPC: Audits of Financial Institutions: 807 Acquisition, Development, and Construction (ADC) Loans

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