Financing School of Hard Knocks

March 1, 2018 by clove Leave a Comment

Several weeks ago, I drafted a post proclaiming that I felt like a million bucks. I’d just talked with our mortgage contact at our preferred lender, who had said things were looking good and our loan application just had to get past the analyst. A couple of days after that, in the midst of last-minute prep for moving out of our house, I got an email listing all the reasons our application was being rejected.

My heart sank. You have got to be kidding! Dreaded visions floated through my head: paying rent + mortgage for months…moving back into our frigid house immediately after moving out…cancelling our contract with our builder…redesigning the whole thing. This was my worst case scenario: someone who doesn’t even know us, hasn’t even had a conversation with us, has decided our project – and by extension, *we* – are not good enough.

Why we were rejected

After I got over the shock (and our move, ugh), I revisited the email, made some phone calls. Time to get analytical and solve this problem. First order of business was fully understanding the reasons they were rejecting us.

We’d specifically gone to this lender, not only because we are members and heard they have the best program for residential construction loans, but also because they’d financed most of the Passive House builds in town. So imagine our surprise when one of the reasons we were given for rejection was the fact that it was a Passive House!

Hang on, what now?

In analyst words, the project was “overbuilt” because it cost more to build than the appraiser gave it value for, and there is a “limited market” for Passive House. Despite me sending along precedents for both rent and sales prices for very similar products now out in the market, the appraised value came in too low. As a result, the assessed value was less than the value of the land plus the cost to build. Hence our project was “overbuilt”.

Given these risk factors, the analyst wanted to reduce the percentage of the final assessed value they were willing to lend (the loan-to-value ratio, or LVR) from 80% to 70%. These things together meant that to even consider moving forward with them, we had to come up with a $234k gift letter (not a loan – specifically a gift) from a rich relative (specifically a close relative, not just a rich friend – sorry, rich friends), because we had insufficient equity/liquidity to pay for the amount exceeding the assessed value. With me so far?

All lending is not created equal

An important distinction: this is a residential construction loan we are talking about here. This type of mortgage is evaluated in the same way as a normal residential mortgage. They qualify us based on our ability to carry the full cost of the mortgage long-term. The interest rates are the same as a traditional residential mortgage and therefore attractively low, but the rules for qualifying are also more rigid and prescriptive than a commercial loan.

While we would really like to fit into this category due to its low cost, our project is a bit of a round peg fitting a square hole. It’s a residential project in the sense that we will renovate the one half and live in it as our primary residence, but it’s also part spec build for the new half (which we will either sell or rent).

Further complicating things, one of the quirky requirements of the residential construction mortgage is that we have to have a certain percent equity (say, 25%) in the final appraised value of the project. So we’re in this delicate situation of wanting the appraised value to be high enough to be more than the land value + cost of construction, but not so high that we don’t have the required equity.

A commercial lender will consider the final appraised value and our cost to build, but is less concerned with our long-term carrying capacity. So in the commercial lending scenario, we need to have a certain percent equity (say 25-30%) in the land value + cost to build, but not in the final appraised value. In their world, the higher the final appraised value, the better.

Now what?

In the weeks since, we met with our wonderful mortgage broker, Scott Travelbea, who helped us brainstorm a few new ideas, but agreed that if we could make it work with this lender, it was really our best bet. He also gave us the name of a private lender he liked, so I gave him a call. I had a great chat with Len, who was very generous with his time and knowledge. He said he could find any number of investors who would be willing to finance our project at any stage and in any amount (he actually googled me. I’m more than just a number on a screen!). That was encouraging to hear. The scary part is that we’d be looking at an interest rate of around 10%, plus these mythical fees that add several more percentage points. Len summed up his lending options as: “incredibly convenient and outrageously expensive!”

Len also agreed that our current lender was our best bet if we could make it work, but also suggested I call our lender’s commercial side, and gave me a name. So I did that too.

Mark in commercial lending was also very generous with his time and expertise. Turns out it’s only the commercial lending side that’s aggressively supporting Passive House at the moment. The good news, though, is that, as a result of my prodding and our mortgage contact’s persistence, the commercial side has now shared what it has learned about Passive House with the residential side and I’ve heard rumour that a residential policy is now in the works.

I talked through our project with Mark and he thought it sounded viable, but he also agreed that if we can make it work on the residential side, it would be the cheapest and easiest way to go. The commercial lenders have more leeway and generally more risk tolerance, but that comes at a price, namely higher interest rates (prime + 1.25% for example); each side needs a lawyer; more thorough appraisals are required (which we pay for), etc. So, feasible, but more expensive.

The differences in interest rates result in non-trivial project costs. In the best case scenario (conventional residential), we’d be in the range of $27-30k in interest charges over the course of construction, plus nominal fees. For commercial lending through a major bank or credit union, $47-50k plus legal and appraisal fees. For private lending, assuming (a probably optimistic) 11%, $100k. Yeowch! The private lender could be a great option to make up a very short-term shortfall, but not at all viable for the whole project. We’ve also heard stories of predatory investors who actually want your project to fail and set up terms that are difficult to meet.

Piling up those lessons learned

To sum up this roller coaster in a few pithy lessons learned, I offer the following:

Construction financing is harder to get than a typical residential mortgage. I.E. plan for more time. Three months has proven to not be enough. Four might be if we are lucky. Which means that we needed to plan for a longer gap between when our drawings were ready to submit for Building Permit (i.e. far enough along for our builder to put together a budget) and when we wanted to start construction.
Construction financing is not really conducive to shopping around to multiple lenders at once. There is more pitching and back and forth and getting to know one another. Hence my first point. If one lender falls through, we’re starting from scratch with our next option.
The less cookie cutter the project, the harder it will be and the longer it will take to secure financing. Our project is definitely not your typical cookie shape. Part retrofit/part new build; part primary residence/part spec build, and Passive House.
The best lender today might not be the best lender tomorrow. When I talk with others who have done several development projects, they say things like “Scotiabank is good right now.” Tomorrow it could be someone else. They get rejected by all but one big bank. And that one is like, yeah, no problem! I’ve also heard many people say that the financing world is just “strange” right now. Whatever that means! Again, refer back to lesson 1 and build in extra time.

Throughout this process (and now well-informed by it), we have continued to work with the residential side lender to revise the scope, reappraised, and resubmit the application in terms that the analyst is comfortable with. Fingers crossed round two will be successful!

We’re Moving!

January 19, 2018 by clove 2 Comments

We have neither our Building Permit nor secured financing, but we are moving February 1!

Because we are raising our existing house and renovating most of the interior, we have to vacate during construction. Plan A was to move to the end of our block and rent our neighbours’ newly created garden suite for a 10-12 month experiment in tiny house living. We were actually very excited about this idea, as well as the fact that we would be a short walk away from our house during construction. But given that our neighbours are also rebuilding their entire house, they’ve encountered enough of their own roadblocks and schedule extensions that our timing no longer aligns.

Plan B, which is really a bit of a miracle given the 0.7% rental vacancy rate in Victoria right now, is to move back into the house we rented when we first returned to Victoria almost 4 years ago. It’s currently empty because it’s part of a whole-block redevelopment proposal inching its way through the public process. It’s a great little house that will fit all our things and it’s literally around the corner from my mom. We also got a discounted rate on rent in exchange for the risk inherent in only being guaranteed tenancy through May 31. I am pretty certain we’ll be able to stay beyond May, but it is possible that we’ll have to move again before moving back into our completed home. Better to not think too much about the prospect of moving 3 times in one year, though. Willful denial can be a very useful strategy to keep us progressing from one step to the next!

Our Building Permit application is ready to be submitted, save for structural drawings that are now being drafted (our structural engineer was sadly delayed due to a personal emergency). I’ve been down to the city a couple of times to check that we’ve included what they want to see, with the intent that once the application is submitted, it will quickly pass through the various departmental reviews. And since we’ve already been through rezoning, I am confident that the Building Permit is a formality. It will happen, it’s the when that could throw things off. The city aims to respond within 4 weeks to a building permit application, but if there is any back and forth over the details, this could stretch out. There is some prep work we can do on the existing house and site in the meantime, though, so I remain optimistic on that front.

The financing is the last big piece of the puzzle that still has me nervous, as it’s really the last point at which someone outside the project can say No and delay it until we find someone else who says Yes. It’s only coming together now because, in order to get financing, the credit union needed an appraisal of the existing house and proposed project. To do the appraisal, they needed a construction budget. For Russ to give us a reasonably accurate construction budget, we needed close to complete drawings. We have all of those things now, and the appraiser has what she needs. All we can do for the moment is pack up our house and have faith that the stars will align!

How Much We’ve Spent So Far

December 8, 2017 by clove 4 Comments

We have arrived at our first moment of financial reckoning. I’d budgeted $30,000 of self-financed work to get us through rezoning.

Here’s what we’ve actually spent:

Building & Landscape Design: $14,000. This includes two early concepts and a redesign; a full set of architectural drawings suitable for rezoning, plus Landscape Plan.
City Fees and Associated Costs: $4,500. This includes the rezoning application fee, the public hearing fee, plus a lot of printing – $787 worth of paper and signage! Forgive us, trees.
Site Survey: $1,350. Required for the application, as well as for our architect Mark A to create the Site Plan
Tree Preservation Plan: $500. Required for the application, completed by an arborist.
Existing House Stuff: $1,900. Includes hazardous materials survey so we don’t unwittingly poison anyone, plus a fee to get rid of our above-ground oil tank. Good riddance!

Total spent through approval of rezoning = $22,500

So, we are currently under budget for the items I had accounted for – woo, party!

Hold the phone, don’t send the invitations out just yet. There are a few asterisks and things I plain neglected in that innocent early budget.

The biggest of my omissions is the Building Permit fee at 1.25% of the construction budget. I’d thought somehow that this fee would be much smaller. Russ our builder is working on the budget as I type, but with my current, ever-escalating working number, we are looking at $11,000-$12,000. Half is due when we apply for our permit and the other half is due when we pick it up.

A few others:

Landscape Deposit – this one was a surprise. It’s required of any project that needs a Development Permit (determined based on location of the project from what I understand), and is equivalent to 120% of your landscape budget. Ouch. It’s a way for the City to ensure we follow through and finish up the landscaping. We’ll get the deposit back, but it hurts to have to come up with this at the front end.
Design package for Building Permit. The design drawings need to be fleshed out in more detail for our Building Permit application and for construction.
Builder Deposit. This goes toward actual construction costs, and provides assurance to Russ before he starts ordering stuff for our project. A reasonable expectation, but something that must be planned for.

For the sake of completeness, there are also some items that I handled myself but would have a real cost if we hired someone else to do them:

My general project development time, which I did not record consistently enough to provide a meaningful total (perhaps better not to know?). Let’s just say a lot of hours – planning the concept, coordinating with the team, consulting with neighbours, coordinating with the city, putting together presentations etc.
Passive House modeling costs. So far, I’ve spent 45 hours on the model. This includes a fair chunk of learning time, reworking, and remembering what I’d done when I put the model aside and came back to it several months later. The model still needs to be updated before we start construction, again after we change anything significant, and then finalized after construction is complete. As the project Passive House Consultant, I will also need to document the construction to show that we built what we modeled. Actual certification requires that we hire someone independent who is qualified, and we’re expecting to spend $5,000 for this piece.

So, overall we are doing OK budget-wise. We are not completely blowing the budget, but I missed a couple of key items in my first pass. This is nothing if not a learning process after all!

We’re working on financing now, so we hope to answer very soon whether this is all going to fly – stay tuned and thanks for reading!

Financing 103

July 1, 2016 by clove Leave a Comment

When comparing our small lot vs. attached duplex development options, I’d heard that financing would likely be more straightforward for a small lot subdivision because we’d have a legal bare lot as security for the lender. With the attached option, we wouldn’t have much until the building is finished.

I’d found a private lender who was not scared off by a duplex/existing building reno; with more flexibility than a bank or credit union, but at a higher interest rate (8-10%). For our project, they would loan one (big) amount to cover our current mortgage and the construction financing. We’d only pay interest on the amount spent, but from day one we’d be paying 8-10% on our current mortgage. With a 10 month construction period, that translates to about $38,000 in interest just for our existing mortgage, and we’d be paying interest in the realm of $50,000 for the whole build. Ouch.

I talked with some other people who have more experience with this stuff, and they suggested we talk with the local credit unions. They will be more conservative than a private lender and more flexible than a big bank, but with interest rates more in line with big bank rates. So I called up a couple of local ones.

The first thing that caught my attention were their rates. Prime + 2% for the construction financing. So, more like 4.7%, which is a heck of a lot better than 8-10%.

Generally speaking, this is how a credit union would structure the lending:

We would terminate our existing mortgage (paying the penalty that is stipulated in our terms – in our case, 3 months’ interest).
We would take out a standard residential mortgage for the existing house, at standard mortgage rates (say 2.8%), which will always be kept separate from the construction loan.
We would take out a construction loan for the new build/major reno. They will charge a 1% construction financing fee and will lend 75-80% of the project’s appraised final value. The 20-25% we need to put in can be a combination of cash and equity.
Similar to the private lend, we would only pay interest on the money actually spent. The money is drawn corresponding with project construction milestones (as verified by an appraiser) – also the same as the private lender.
We would have to self-finance to a point. That point is AT LEAST after approval of rezoning, but depending on which option we pursue, and who the lender is, may vary beyond that. For the small lot subdivision, it’s likely we’d have to self-finance past rezoning approval and to the approval of the subdivision, which may or may not include completion of the subdivision. This is a pretty big grey area, since the cost to fully service the lot (required to complete the subdivision) was quoted to me by the city as being in the realm of $25,000 – $30,000.

One of the credit union mortgage specialists I talked with got really nervous when I told her we were raising the existing house. She said that in this situation, they might be limited to lending based on land value alone. The other credit union rep I talked with, on the other hand, said they were comfortable with house-raising (and in fact, she enjoyed seeing the pictures of the lift in progress).

In conclusion: The local credit unions offer better rates and a more attractive solution for either of our proposed options. The difference in costs between private lender rates and credit union rates could be as much as $30,000, which is a significant amount of money for a small project like ours. And it’s money that would disappear with no equity coming out the other end. We will be much better off going through a credit union provided we can meet their requirements. Also, the credit unions seemed comfortable with either option: small lot subdivision or attached duplex.

I would recommend calling several lenders as you’re planning your own project – private lenders, big bank, and credit unions. Even among the credit unions, their comfort level with our particular project varied.

And on that note, Happy Canada Day!

Financing 102

January 1, 2016 by clove 2 Comments

There is hope for our project yet. I recently met Damian from a mortgage broker firm that also self-finances projects like ours. Their rates are higher than a conventional lender, at 8-10%, but they also offer more flexibility. For example: with 25% equity in our existing house, they could provide us a loan that covers the entire property during the construction phase – the existing house mortgage, the improvements to the existing house, and the new house construction.

A conventional bank will offer better rates, but is likely to lend for the new build only, and only after the new subdivided property is registered. If we have to move the existing house in order to register, we may find ourselves in a tight spot financially.

I confess that some aspects of the financing still mystify me. I did, however, leave my meeting with Damian feeling confident that we will be able to finance our project with the money we have. Exactly what the financing and construction sequencing will look like remains to be seen.

Here is a snapshot of our current budget. The total number is higher than I want to see, but it is a conservative starting point. It includes both the new house build and the existing house renovation. The larger line items – like General Contracting – are currently very round numbers that will be refined with their own detailed budgets as we move forward.

Pre-Construction Budget:

Site Survey
Preliminary Design
Design for Rezoning Package:
1. Architectural design and plans
2. Landscape design and plan
3. Site servicing plan
4. Structural engineering (as needed)
5. Tree preservation plan
6. Planning guidance
Rezoning Application Fees

Pre-Construction Subtotal: $30,350

Construction Budget:

Hazmat Survey
Additional Site Marking
Existing House Lift
General Contracting (new build + exterior work on existing)
Existing House Interior Renovation
Architect Services During Construction
Legal
Financing Costs

Total Budget: $677,350.

The Pre-Construction subtotal is critical to get a handle on because no one will lend us any money until our rezoning application is approved. This up-front investment is out-of-pocket, and therein lies the risk in a development project.

The “financing costs” item is also an important one, and it ties back to my initial discussion about financing options. We need to understand the total interest we can expect to pay for a construction loan. In our “worst case scenario” the initial draw is high because we would have one loan for everything (existing mortgage, reno and new build) and we’d therefore be carrying the mortgage for our existing house from Day 1. In this case, we are looking at ~$42,000 in interest for a 10-month construction period – not an insignificant amount of money!

Another potential option would be selling the new house after we have received all approvals but prior to construction. In this scenario, we wouldn’t need any financing and we’d pay for the existing house renovation with funds from the sale. An attractive option, but not one that we want to count on just yet.

So we have some options and it feels good to have options!

Financing 101

June 26, 2015 by clove Leave a Comment

So I don’t actually know yet how we are going to pay for our project. I know, right? The trick is that if you haven’t done it before and just “know”, you don’t really know until you have a designed and appraised project. This is what the many lenders/brokers I talked with asked: do you have a design? Do you have an appraisal? Well, no, I was hoping to get some answers before we committed. But it seems to be one of those things we will only really learn by doing and bumbling through.

Here’s what I do know, and the basis for my high level confidence that our project makes financial sense:

We bought the house for $565,000. We can build the attached or detached new house for $300,000-$400,000, and we can renovate the existing house for around $200,000. If we built an attached addition, we could sell it for $500,000 – $600,000, which covers the cost of the new build and the renovation. We are then left with a renovated house with a suite for the same cost as the original house, but with the added rental income. So overall, our project makes financial sense. If we go the detached route, the construction cost numbers don’t really change, but the sales price is likely closer to $700,000.

But wait! There’s a piece in between: regardless of how good the end picture looks, a lender is not going to lend based on future potential alone. And! The lending scenario looks different if we go with the attached/strata option versus subdividing and building a separate dwelling on its own titled lot.

Here’s what I learned from our mortgage broker Scott Travelbea, who did his own lot subdivision development project a couple of years ago:

For both the subdivision and attached dwelling options, we need to self fund the project to the point where we have approval for the subdivision/rezoning and/or development permit application. However, for the subdivision option, once we have that new lot serviced and titled, it now has real value to a lender, and they are willing to lend against that serviced lot. If the project fails, they have something of value that they can turn around and sell to recover their costs.

In order to be approved for a loan on top of our existing mortgage, we also need to have 20% equity in the existing house, and some money to get the construction started.

In an attached duplex/strata scenario, we need to be much further along in the construction before a lender will be comfortable throwing money at us. If we screw up the project and don’t finish, there isn’t much of value for the lender to recover, given shared land, shared walls etc.

So let’s look at our numbers for the detached option:

We have $80,000 down on the existing house on a purchase price of $565,000 (14%).
We currently have $100,000 and change in the bank to fund the rest of the project.
Say we can limit upfront design and rezoning application costs to $20,000.
Once the project is approved, both houses will be re-appraised and we may need to put in some extra cash to bump us up to 20% equity in the existing house – let’s assume another $30,000 (based on the purchase price).
Then we need some cash to get us through to the first construction phase draw – if $50,000 is enough to get started here, we are in business.

My current feeling is that if we do, in fact, have enough money now, we barely have enough money now.

The downside to doing a detached option is that we do not get the additional passive benefit of the combined building volume (minimizing our exterior surface area to internal volume ratio). However, we can sell a detached house for more than an attached strata duplex, at roughly the same cost to build. The detached option is easier to manage long-term since there is no common property. We may not meet Passive House standard, but ultra low energy/net zero is still feasible with a simple smart design and a good enclosure.

Why we were rejected

All lending is not created equal

Now what?

Piling up those lessons learned

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