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:

1. 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.
2. 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.
3. 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.
4. 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!