By: Dustan Woodhouse
Is your client thinking about building their own home? Will they require any level of financing along the way? Suggest they start at the very beginning with an in-depth project review with their mortgage broker, one that is specifically experienced with construction mortgages. In fact, have this conversation prior to their purchasing the lot if possible.
Land financing is not as simple as it once was. Nearly every lender 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 per cent of the value, the maximum being 65 per cent, and typically at Prime +2.00 per cent rates, what is currently five per cent.
Land includes that lot your client is looking at with the dilapidated shack on it that passes for a home. If that’s not a home your client would live in, then they need to be concerned about how a lender, in particular an appraiser, is going to view the property.
Please urge your client to have a conversation with their broker before you write the offer, especially a subject-free offer, which is to be avoided at all costs in my opinion, as we often see in Vancouver.
So, your client owns the lot now, what next?
Both what your client is building and being liquid enough to complete matter immensely to the lender. Working out the mathematics on the true liquidity requirements in advance is vital.
Perhaps the No. 1 thought to keep in mind is that lenders finance the value of what your client has already created – they do not provide advanced 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 about 35 per cent complete (i.e., a foundation, framed, roof, doors, windows, etc.).
Once your client builds (a portion of) it, then they receive a percentage of financing for what they have created.
This is where the math gets a bit trickier, so we will just look at basic cash requirements here;
1. Purchasing a $1 million lot without a building on it, or with a rough structure.
- Your client will need 35 per cent down, in this example $350,000
- If there is a reasonably inhabitable home on the property, they’ll need 20 per cent down, or $200,000
2. 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: the 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.
If your client has not entered into a proper construction mortgage, and they demolish the dwelling on the property, they risk having the mortgage called and ending their relationship with that lender in a very difficult way.
Conventional construction mortgages will not put cash in your clients’ hands until the new structure is about 35 per cent complete.
Funds are required to demolish the old structure, prepare the lot, lay the foundation, frame, roof, install windows and doors and get the structure to 35-per cent completion before a bank or credit union will advance another penny past the initial 65 per cent to 80 per cent of the lot value already advanced.
In the case of our $1 million 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.
Many a new home build stalls due to monies running dry, and it is not a pleasant experience. It almost always has as much to do with poor planning as it does with budget run-overs. Even a few weeks of delays 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 individual’s 91 per cent complete project as the current owner ran out of access to capital to get to the magic 97 per cent completion 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 your client has spent the $250,000 to get to their first advance, depending on how the construction draws were set out, they may well not have been handed enough money to make it to the next draw milestone. I say milestone as the release of funds is set in stone at certain percentages with institutional lenders.
It is not about how much of a mortgage your client will need at completion, it is 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 is 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 that have been placed. We have never seen an exception to cost in place.
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 is not so simple.
It is all about planning from A to Z, not simply A to B. Most importantly, ensure your client has a plan so they don’t get stuck looking for a way to get from J to Z.
Self-builds are also currently challenging to finance, 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 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.
“My business makes lots of money” is not as 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 an accountant leads to good news from a mortgage broker.
Make sure all of the detail ducks are in a row before your client signs on the line which is dotted.