Construction Financing – These Files are Not all Built the Same.
Unless you build something that is perhaps less ‘marketable’ than what is conventionally found in the neighbourhood.
Thinking about building your own home? Will you require any level of financing along the way? Start at the very beginning with an in-depth project review with your Mortgage Broker, one that is specifically experienced with construction mortgages. In fact, have this conversation prior to purchasing the lot if possible.
Land financing is not so simple as it once was. Nearly every lenders now requires plans and a build sheet up front in order to finance the land alone. Lenders want to see exit strategies on land files. The few willing to finance land are very picky about the client and property, and rarely will offer greater than 50% of the value, the maximum being 65%, and typically at Prime +2.00% rates. Or 5% currently.
‘Land’ includes that lot you are looking at with the dilapidated shack on it that passes for a home. If you would not live there with your family, then you need to be concerned about how a lender, in particular an appraiser, is going to view the property.
Please have a conversation with your Broker BEFORE you write the offer, especially a subject-free offer (Subject Free is to be avoided at all costs in my opinion, and the dangers thereof the topic of an upcoming post) as we often see in Vancouver.
So, you own the lot now, what next?
Both ‘What‘ you are building and ‘being liquid enough to complete‘ matter immensely to the lender, and to yourself as well of course. Working out the mathematics on the true liquidity (Cash) requirements in advance is vital.
Perhaps the #1 thought to keep in mind; Lenders finance the value (% of structure) you have already created (built) – they do not advance you funds to build something where there is nothing.
Construction financing is not defined as a lender advancing funds with which one builds a home, rather it is a case of the Lender advancing funds based on the percentage of the home completed. Typically the first dollar (aside from the land advance) is not released to a client until the structure is ~35% complete. i.e. a foundation, framed, roof, doors, windows, etc. A ‘locked-up’ structure exists.
Once you build (a portion of) it, then you receive a % of financing for what you have created.
This is where the math gets a bit more tricky, we will just look at basic cash requirements here;
- Purchasing a 1M$ lot without a building on it, or with a ‘rough’ structure.
- You will need 35% down, in this example $350,000.00
- Possibly 20% down if a reasonable inhabitable home. $200,000.00
- Commencing Demolition and Construction
***When purchasing a house which one plans to tear down, the risk is often hidden in a measurement not thought of by many buyers ‘Remaining Economic Life’ which is predicated largely on the condition of the property as well as the age of the home in relation to those surrounding it.
If there is not enough ‘Economic Life‘ remaining, the lender will treat it as a “land deal” and price the financing accordingly. (i.e. 35% down @ 5% or higher)
***If you have not entered into a proper construction mortgage, and you demolish the dwelling on the property, you risk having your mortgage called and ending your relationship with that lender in a very difficult way.
Conventional (A-rates) construction mortgages will NOT put cash in your hands until the new structure is ~35% complete or at ‘lock up’
Funds are required to demolish the old structure, prep the lot, lay the foundation, Frame, Roof, install windows & doors and get the structure to ‘Lock Up’ before a Bank or Credit Union will advance another penny past the initial 65% to 80% of the lot value already advanced.
In the case of our 1M$ lot, perhaps we have an $800,000 build, almost certainly lock up will cost all of $250,000 to reach.
Now the total liquid cash requirement has risen to a minimum of $450,000 or as much as $600,000.
- The true challenge – Reaching Completion.
Many a new home build stalls due to monies running dry, it is not a pleasant experience. It almost always has as much if not more to do with poor planning as it does with budget run-overs. Even a few weeks of delay in funds can send shock waves through a well orchestrated build plan adding months of delays.
Another Broker in our office is currently completing a purchase transaction for a client buying another individuals 91% complete project as the current owner ran out of access to capital to get to the magic 97% complete point where monies are released and interest rates adjusted to AAA rates.
Budgeting properly based on what the true draw schedule reflects is vital.
When you spent the $250,000 to get to lock up and got your first advance, depending upon how the construction draws were set out, you may well not have been handed enough money back to make it to the next draw milestone. I say milestone as release of funds is set in stone at certain percentages with institutional lenders
It is not about how much of a mortgage you think you will need at completion, it is ALL about setting out the draw schedule to account for and accommodate over-runs and shortfalls.
When it comes time for progress draws it’s important to remember that the lender will only consider “Cost in Place” which means that if the materials are not “installed or screwed down” their cost will not count towards completion. This of particular importance as suppliers often ask for large deposits for windows, cabinets, doors, etc. The lender will not include items that are paid for but not installed or factor in deposits which have been placed.
COST IN PLACE. We have never seen an exception to this.
It is also important to note that lenders are equally unlikely to enter into construction financing mid-build. A lender wants to see the complete plan up front before the first shovel full of soil is moved. Jumping from one to another midway through when you have trouble – not so simple either.
It is all about planning from A-Z, not simply A-B. Most importantly not getting stuck looking for a way to get from J-Z.
Self-builds are also challenging to finance currently, primarily due to owner/occupied builds being a one-off often completed by an individual with limited experience and even more limited industry connections to reliable trades.
Be aware that custom homes may not always meet the standard construction schedules used by lenders either. An example being construction on a steep hillside requiring extensive blasting, geo-tech, and foundation work. This can easily leave the builder short of funds well before the first draw. For custom homes, it is best to have significant cash reserves budgeted for shortfalls and overruns.
Having a team of (New Home Warranty Certified) professionals involved is key.
That (new) old story about documented income, that is a pretty important one these days as well. Lenders care deeply about their clients line 150 documented personal income as shown on their T1, and the composition of that income will be looked at closely. Less so about earnings retained in a Corporation.
‘My business makes lots of money’ is not helpful, as it once was. What is helpful? ‘I pay a load of personal income tax on my significant Line 150 income’.
Bad news from your accountant leads to good news from your Mortgage Broker.
Rates on construction mortgages are typically Prime +2.00% (5% currently) and the draw mortgage floats as a line of credit with interest only payments until completion, at which point the initial lender selection becomes very important as many have fine print locking clients at completion into 5 year fixed mortgages at uncompetitive rates.
The lending landscape is changing (tightening) in this area of lending as well.
Make sure all of the detailed ducks are in a row prior to signing on the line which is dotted.