Handling Policy Changes From The Lender
Welcome to the Real Estate Espresso podcast. Your morning shot at what’s new in the world of real estate investing. I’m your host Victor Menasce.
On today’s show we’re talking about the importance of conservative underwriting. Lenders are not business people, they’re not real estate investors, and they don’t know how to manage risk in the broader sense of the word. They use relatively blunt tools to manage their risk.
Both the US and Canada have programs that are designed to facilitate new supply coming into the market. The US program for large scale development is administered by the Department of Housing and Urban Development. There’s another facility under the small business administration program and the US Department of Agriculture also has programs that are available in certain parts of the country. In Canada, there’s a construction-to-PERM program administered by the Canada Mortgage Housing Corporation or what we call CMHC. This program provides preferential financing terms for projects that are bringing new supply into the market.
Both HUD and CMHC are not lenders directly, but act as guarantors on behalf of the lender. They help reduce the risk for the lender as an inducement for the lender to make the loan in the first place. Naturally, the program does not want to see a high default rate. The Canadian program offers up to a 50-year amortization on construction to PERM loans as long as it meets the criteria for the loan.
In addition, the loan provides for up to a 95-percent loan-to-cost financing for new construction. During the last year, there have been two amendments to loan policies this year that some might consider significant. These have made it more difficult to get financing under these loans and have made the loans less attractive. The first change is that in order to qualify for the maximum number of points for the 50-year amortization, you would need to supply a percentage of affordable units as part of your project. Housing affordability is a major issue in Canada, just like it is in the US. By requiring some affordable units in the mix, the income for your underwriting is negatively impacted.
Our analysis shows that we’re actually better off securing a smaller number of points and accepting a 45-year amortization instead of 50, which is still an extremely attractive set of terms. The next change to be implemented was announced a little over a week ago. In this case, the loan ratio was reduced from 95% on construction loans to the range of somewhere between 80% to 85%. That’s particularly true for large projects. The reduction in loan ratio allows for loan, but only once the project achieves its set coverage ratio on stabilization. That means that the developers need to bring more cash to the table up front, and they can still get a high-ratio loan, but only when the development risk has been removed.
The marketplace is buzzing with chatter about the death of the funding program—it starts to look a lot like financing a construction project with conventional financing and then refinancing into a higher ratio stabilized loan. In fact, the information from CMHC suggests that conventional construction financing may in fact be the most attractive option.
The truth is, we never assumed the most aggressive loan ratio in our own underwriting—we always underwrote our projects assuming a much more conservative stance. As a case in point, when we plugged the new rules into one of our upcoming projects, the impact was negligible. So, the question is, why were we so insulated from the changes? Well, quite simply, we were underwriting.
That is one thing to just say be more conservative, but that doesn’t provide much insight. How much more conservative? What are the criteria that make sense? Let’s start with the major variables—rents are determined by the market, and we always commission a third-party market study to make sure that we’re not deluding ourselves when it comes to market conditions. The second thing we look at is the rate of inflation. We know that inflation exists, so we perform both a trended and untrended analysis. Untrended is more conservative, and that’s what we generally use. Of course, we do look at both.
When it comes to construction costs, we work with third-party cost consultants, who have surveys of the industry, and they certify our costs before a lender accepts our sworn statement of construction. We look at the yield history of a ten-year treasury, which sets the index for most permanent financing, and we use that to set our forecast of what we think it’s going to be a few years out. And then there’s the lending ratios. There’s debt coverage ratio. Conventional lenders require a debt coverage ratio of 1.25 for residential, sometimes higher, maybe 1.4 or 1.5 for commercial, and sometimes a lender will increase its debt coverage requirement.
For a construction lender, the biggest factor of safety lies in requiring more cash up front and larger reserves over and above the quota cost of the project. This can translate into a lower loan-to-cost ratio. Sometimes the lender will be clever from a marketing perspective and maintain the 100% loan-to-cost ratio constant, but they exclude certain expenses from being included within the scope of the project. It forces those expenses, to be funded 100% out of equity. It achieves the same objective without the negative perception of a lower ratio. So there’s no exact science. If we feel that a long-standing debt coverage ratio, like, for example, 1.18 with a HUD loan is going to remain unchanged, then we’ll use that number. Failing that we’ll need to use a more conservative 1.25 debt coverage ratio like you would find with agency financing. We keep our finger on the pulse of what’s happening in the market. And if you fail to do so, and if you fail to have any buffers hidden somewhere in your underwriting, you’re going to be ill-equipped to handle surprises when they happen. As you think about that have an awesome rest of your day, go make some great things happen, and we’ll talk to you again tomorrow.
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