At Concert, we view our lenders as financial partners. Partnerships, like many things in life, can be wonderful if managed well. Poorly managed partnerships, however, can be a serious risk to the health of an organization. Over the past decade the market has had, and continues to have, excellent liquidity and relatively low interest rates. However, the market for mortgage debt, like the broader real estate market, is cyclical in nature. Through both good markets and bad, having a thoughtful and clear financing strategy will be critical to your success.
THE BASIC ELEMENTS OF FINANCING
Types of Mortgages
There are several different types of mortgages in Canada, including:
- construction mortgage (which includes development/land servicing)
- term mortgage (also known as a take out mortgage)
- joint construction and term mortgage
- land acquisition mortgage
The security of a mortgage can have different priorities on title. With a first mortgage, the lender is the highest priority on title and gets their money back first in the event of a default. With second and third mortgages, the lender is not first in line to get their money back on a defaulting mortgage, so lenders will charge a higher interest rate for this greater amount of risk. Often these mortgages help to bridge the gap between a first mortgage and the equity required from an owner or developer.
Types of Properties
The different property types that can be financed commercially include:
- residential (condominium, multi-family rental, seniors)
- office, industrial, and retail
- institutional and hotel
- mobile home parks and agricultural lands
Each property type has its own set of risks and rewards and lenders will offer different mortgage terms and lender protections given the different risks associated with each property type.
There are also types of property ownership that affect loans: freehold and leasehold. Most loans assume freehold ownership; however, a loan based on leasehold ownership affects a lender’s security and potentially diminishing property value. Questions to consider: What is the remaining term of the leasehold interest (10 versus 99 years)? Is it a prepaid lease or are there annual lease payments that escalate over time? Are those annual lease payments reset over time at a defined calculable rate or is it at a market rate that can be debated? Is the landowner a government agency, First Nation, or a private entity? Is the landowner’s process predictable and accountable?
Types of Lenders
Just as real estate buyers are diverse in Canada, there is extensive diversity and variety among lenders. Some of the key lenders in the marketplace include:
- pension funds
- insurance companies
- chartered banks and credit unions
- institutional and private syndicates
- private equity firms
Lenders have limited capital to deploy during a given period, but they need to maintain their portfolio diversification and a return threshold. The diversification relates to such factors as type of properties, city location, age of buildings, and remaining length of the mortgage term. These portfolio factors, which vary between lenders, are ever-changing as they are influenced by market shifts and the state of the economy. Each lender will have different risk tolerances, which will limit what type of building or project they will be willing to lend on.
The Team
You are only good as your team. Make sure you pick a highly experienced consulting team when you finance. A solid team would include:
- finance lawyer
- environmental consultant (soil, vapor, water, habitat)
- building condition consultants (structural, architectural, mechanical, electrical, plumbing, etc.)
- geotechnical consultant
- surveyor
- appraiser
- title insurer and deposit insurer
- mortgage broker and insurance broker
Make sure that you choose consultants who are approved by the various lenders from which you are seeking financing. If not, the lender will likely not accept their report or advice on your project.
Borrowers who do not have the in-house expertise and lender relationships, or perhaps do not have the capacity to manage the team and process, should consider using a mortgage broker who can help them navigate through the complexity and array of mortgage financing.
Canada Mortgage and Housing Corporation (CMHC)
CMHC offers insurance to encourage the development and retention of multi-family market rental projects in Canada. Although there is a premium charge for this type of insurance, lenders will bid a lower spread for the CMHC-insured mortgage as the mortgage is backed by a federal Crown corporation. In addition, CMHC has now taken a greater role—from being an insurer to being a lender—in encouraging the development of affordable housing.
SETTING IT UP
Some of the most critical work that is required when setting up your financing strategy is to ask some hard questions within your organization. These questions will help form your financing strategy and ultimately determine the risks you are willing to take.
What is your corporate objective? Different developers and investors have different objectives, which will influence the financing approach. Some want to maximize the LTV and stretch their equity as far as possible even though it bears substantial financial cost. Others want to be more conservative and put more equity to work while maximizing the amount of profit. There are benefits and drawbacks to the different approaches. Have you and your investors agreed on the level of risk to take for the potential reward? How much equity do you have now?
What is your project-specific objective? Is the project significant to the financial outcome of the overall enterprise? What are your return metrics? How attractive is the asset to potential lenders? How can debt be used to execute your objective, such as enhance your return, reduce the equity required, or free up equity to reinvest in another project?
Does the project not work financially given certain interest rates? How much financial flexibility and strength do you and your investors have if the project is delayed, the market goes sour, or if interest rates change during construction?
To obtain a better interest rate (or in some cases to even secure the financing at all), are you prepared to put your balance sheet on the line and make the financing a recourse loan to the parent company rather than only to the property? Are you prepared to have someone be an indemnifier/guarantor?
Once you are clear on your own objectives and what you’re trying to accomplish, it’s time to put together your financing package and go to market.
FINANCING PACKAGE
To create your package, you will need to include, at minimum, the following information:
Project and deal:
- objective
- project highlights
- preferred deal terms
- project details, timeline, zoning and entitlements, and market analysis
Borrower:
- executive leadership team, bios, and organization chart
- track record, experience, and past projects as a developer
- financial strength
- key references
Schedules:
- project development plans and renderings
- pro forma with scenario analysis
- current and past audited financial statements
- environmental, building condition, and geotechnical reports
- appraisal, survey, and title
- fixed price construction contract
PROCESS
Once you have the financing package assembled, it is time for you to go to market. Either directly, or through a mortgage broker, you can now connect with the various lenders who fit the risk profile of your given project. Each lender will have their own underwriting team who will evaluate your proposal and have a series of questions.
Once the lender is satisfied with the project details and deliverables, you will receive their proposal. Some critical aspects of the loan will include:
- loan amount and interest rate or spread
- term and amortization period
- type of security: recourse or cross-collateralization
- application and commitment fees
- representations and warranties
- due diligence and title review requirements
- pre-sale and estoppel requirements
- ongoing DCR/LTV covenants and pre-payment provisions
These loan terms are important, and they usually work together. For example, fewer pre-sale requirements and less security would likely result in a higher interest rate or lower loan amount.
Does this lender have the same core values and business culture that you have? Core values and business culture impact strategic direction and influence management, decisions, and key business lines within an organization. If the core values and culture aren’t aligned between you and your financial partners, no matter how attractive the specific terms of the financing proposal are, it will be difficult to achieve a longstanding and prosperous relationship.
Once you choose the proposal and lender, a commitment letter will be prepared. To ensure smooth execution on the financing, a prudent borrower will only agree to provisions in the commitment letter they are certain they can execute prior to the proposed funding date of the loan. The lender will then complete its due diligence and will have its lawyers prepare the closing documents with your lawyers.
Sometimes there are new, last-minute due diligence or leasing items that surface or additional lender requirements that arise unexpectedly. You should anticipate the needs of your lender and proactively solve their issues of concern, as this approach will expedite the process and build trust.
FOSTERING SOLID RELATIONSHIPS WITH LENDERS
Our experience has taught us that lenders value honesty and transparency; they value a borrower whose word is their bond. Lenders also value borrowers that execute their projects well. These attributes lead to a relationship of trust, strong execution, consistency, and reliability with your lender.
While it is important to have loyalty among partners, prudent borrowers must be sure to diversify their base of lenders and financial partners. In a cyclical business such as real estate, when the ups turn to downs, the relationship built and nurtured during the good times will pay off in the tough times. For borrowers, lenders must not exceed the credit connection limit, which is the total amount of funds a lender is permitted to loan to that borrower. Likewise, prudent borrowers will ensure they are not beholden to any one lender.
FINAL THOUGHTS
The use of debt financing is an important tool in the toolbox for real estate investors. Each owner or borrower will have their own unique objectives when setting up the mortgage financing. Each lender will have their own unique risk return profile and portfolio considerations. In this dynamic marketplace, there are hard-working, sophisticated, and diverse players on both sides of the transaction. Starting early, and following a disciplined and thorough process, will help achieve a mutually beneficial financing transaction.
At the end of the day, real estate investment (including debt financing) is a people business. Just like in any relationship, if your lender trusts that you will keep your promises and be a good steward of their interest (their money and their reputation), then the sky is the limit to what you and your lender can accomplish together!