Avoid Pitfalls in Financing your Construction Project
Richard Lewis helps take the mystery out of financing your construction project.
Jeffrey: This is Jeffrey Veffer from Incite Design, and we are often asked at an early stage in a project about some of the financing options that clients might use to finance their renovation or complete new build. I’m very pleased to have with us Richard Lewis, who’s going to talk a little bit about the different options, and also talk about some of the potential pitfalls that clients may not be aware of. Richard, I was wondering if you could tell us a little bit about your background, and a little about how you got into this industry?
Richard: Hi, Jeffrey. Thanks for having me. My name is Richard Lewis, and our brokerage is Lender Direct Capital Corporation. Our offices are located at 162 Cumberland in Yorkville. I’ve been in the mortgage business for over 35 years, and our reputation is for industrial, commercial, and private financing. We specialize in construction, financing for the GTA, as areas as far away as Ottawa, included up to North Bay and out to Windsor. Current market conditions for construction financing, the banks typically are the first go-to sources for home improvement loans or major construction facilities.
What most homeowners find, and it actually works quite well, is a homeowner’s line of credit. So if your existing property is worth $1 million, providing you meet the debt service requirements, the bank will register a facility that will generally take you up to about 80%. So that round number would be $800,000, and then you would have access to the funding between what the mortgage balance that you owe, perhaps $500,000, and the line of credit limit. You can use that facility to do your improvements, and it’s generally at a very competitive rate, prime plus a half, or in that range.
The facility generally is interest only, and once it’s exhausted or run up to the limit. If it’s not paid off, it could be combined with the term portion of your mortgage. That’s probably the most advantageous for those that are available to achieve that. It does require certain income and debt service ratio requirements, and the bank is flexible on how they advance the money, since it’s your money and it’s your line of credit. So the advantage with that facility is there are generally no construction lien holdbacks. You draw the money, you pay your trades and supplies, and it’s all on you to monitor the progress and success, or difficulties that come with it.
For those that don’t have the ability to utilize a homeowner’s line of credit, or “HELOC” as it’s called, the banks will sometimes look at structuring a construction facility from a grassroots standpoint, offering a gain of a certain percentage. But it’ll be perhaps up to 75% or 80%, which they can do uninsured. They generally will advance that in construction draws on a work-in-place basis. The problem with that facility and for most homeowners is the advances are based on updated appraisal and work in place, and subject to a 10% holdback under the Construction Lien Act.
Which typically leaves a shortfall between what’s required to pay the current obligations to their trades and contractor, and what money they’re actually offered. So what inevitably happens is they end up short and either dragging their trades, or leaving bills unpaid, and it can actually cause work stoppages and problems. What we offer for private financing is we’re not obligated to observe any particular format for advances. We can advance based on need, rather than a particular structure. Providing we have adequate security, we can even agree to waive the construction lien holdback provisions.
So typically, say, for example, windows might come in the second draw of the major renovation or new build, where the money to order them may be required from the first draw, or from the onset of the project. But that’s something we can accommodate. We also only charge interest on advance funds. So you take as little as you need to get through each draw. Once the project is complete, we recommend people go back to their bank and secure a conventional term loan at bank rates, and that’s pretty much it.
Jeffrey: That’s really interesting. You bring up some great points in there. One that maybe we could address is the kind of time delay if you’re using a bank facility between when you’re required to pay for materials or when your contractor requires you to pay for materials, and when those materials are actually installed. Like you mentioned, with windows, we know from our experience as architects that they have often an 8 to 10-week delivery window. So those need to be paid for. It takes 10 weeks to get them onsite. But yet, they won’t be installed maybe for another month or two.
So it gets to be a little complicated juggling the payments from the bank so that you’re not underwater all the time. Then, you have to scramble to get alternate financing to pay all the bills, which are coming in that are due. So is there often a case where clients go, they get a bank facility, like you said, for $300,000? In today’s construction market, even in renovations, that’ll get you started. But there’s often a case where you require another $300,000, $400,000, maybe even $500,000 to finish off the project. So at that point, do they go out and look at alternate financing options then?
Richard: Yes, Jeffrey. You raise a really good point with that. In fact, what we see more times than not are projects typically run over budget anywhere from 10% to 20%. So with the bank facility and the holdbacks, there’s rarely enough money to accomplish what needs to be done in terms of payables. Your example of windows, 8 to 10, to 12 weeks, sometimes that can be even extended longer than that. What the banks typically want to have happen is when you require a draw, they request an updated inspection report on the property with an appraisal. Then, may lend a percentage of that based on the particular loan to value or ratio that they’ve established, whether it’s 75% or 80%.
Once that’s accomplished, it can take a week to two to get an updated appraisal, and then it can take another two to three weeks to get the legal work done. Each time a draw is to take place, a lawyer must sub search the property to make sure the title is still clear and there are no construction liens registered before the bank will advance. We can streamline that process by doing it instantaneously, and in fact we have our own inspection process. That way, instead of weeks, we can turn it into days if needed to actually get money in the homeowners’ hands.
The difficulty with not having the funds available is you may have to tap into RSP money, friends, family to float the project. Because essentially, what happens is on a work-in-place basis, you’re responsible for making the payments and paying your trades, and recouping the funding from the bank. Whereas, with our structure in private lending, we can offer the money directly to the trades if need be, or through a direction, you can make payments to the trades on a timely basis. Quite often, homeowners find that they get better pricing if trades and suppliers know they’re going to be paid on time and not have to wait several weeks or months for payment.
Jeffrey: Yeah. That’s right. Everyone has seen the construction sites in their neighborhood which never seem to get worked on after a certain point. Maybe they’ve got the windows in. There’s one in my neighborhood which has got windows in, the roof is on, but the entire interior is gutted, and it’s been sitting for months. It’s a tragedy if you’re not able to have your funding keep up with your actual project. The other situation is, I know, some clients come to us and they say, “Do we really need an architect to work on the project?” Well, that’s one of the functions of an architect is to bridge between the contractor and the homeowner, as well as approve payments based on percentage of work completed.
So in that way, we kind of have a bit of two-sided responsibility, one to the client, but also to make sure that from a work-in-place point of view that we can recommend whether work has actually been done or not. So the client is not always behind in terms of the amount that they are paying to their contractors.
Richard: No. That’s an excellent point, Jeffrey. In fact, it’s a great check and balance to have in place. Because unless you’re a professional homebuilder, or have a professional such as yourself monitoring the project, homeowners can actually be taken advantage of in a number of areas by both suppliers and by tradesmen, unfortunately. So it’s very good to have that monitoring in place, so that they know that if some material and supplies have gone into their project properly, then they’ll be paid. If they haven’t gone into the property yet, or they’ve been misdirected elsewhere, that that’ll be caught and the homeowner protected.
Jeffrey: Right. Now, another thing I’d like to chat about is the difference between a renovation, which can involve a significant amount of work on a property, but structurally maintains most of the existing house, versus a complete new build where the existing property is demolished. Are there any differences in terms of the way that the financing is arranged from the bank’s prospective?
Richard: Yeah. There are some flexibilities with renovations versus rebuilds with financing, and that’s the typical major renovation where they’re not demolishing the building and starting from scratch, and from coming out of the ground. With a renovation loan, if the property has a good existing first mortgage on it, we’ll consider advancing the funding need be by way of a second mortgage on the property. Which means they can take advantage of the lower rate bank mortgage and maintain a relationship with the bank. Then, on completion go back to the bank and ask to consolidate the second mortgage portion of it, which was used for the home improvements, based on an improved value appraisal.
The banks like that, they typically don’t like getting involved in construction projects. They don’t really have the resources or the expertise for it. So what they do like, though, is lending money. Going back in to combine that to a low-rate first mortgage on completion makes good sense. Not only for the homeowner, but also for us as it creates an exit strategy for our finite supply of funding for these types of projects, so we can revolve it over to the next person who needs it.
Jeffrey: Yeah. That’s a really interesting option for a lot of homeowners, is that they’re really not aware that the bank is not structured to do construction, because it’s a little bit vague. It’s not secured, and with a lot of the challenges that have happened in construction, projects not getting done or legal disputes, they need to make sure that their funds and their shareholders are protected. So they often take other measures to make sure that the project is very secure to them, but that could also leave the clients in the lurch when they need to come up with this extra money.
Richard: Jeffrey, you know, each year we have a number of requests and transactions that speak directly to that, where people have gotten involved with a bank for a construction project, and ended up in a position where the work in place is not justified in advance, and the project stalls. The only way to get it going again is for them to inject capital from their own resources, which if unavailable means they have to look alternatively. Quite often, we’ve had to jump in and take over a construction project midstream, and get it moving again by advancing the necessary funds.
We do it [in improvement] fashion to ensure that not only our investors, but the homeowner is protected and the process is being advance in a wise and prudent manner. So we have a number of requests like that. Unfortunately, for some homeowners, by the time they reach that point where they realize that there’s a faulty structure from the onset, it’s too late.
Jeffrey: Yeah. That’s tragic for everybody involved. Not only the homeowner, but also the trades who have often done work and they need to get paid, because they’re looking to pay their workers. It just backs up the whole system. So it really is prudent for homeowners and clients to understand the financing structure of their project about what the budget is going to be, whether they have enough resources, and the different combinations that they can look at. So that they can sustain themselves through the prolonged construction period.
Because they’re not only worried about the fixtures which go in, but also the rent that they have to pay on an adjacent property they’re living in, and a lot of other unseen costs which come up towards the end of a project. So it’s really a lot for a client to worry about. As long as they employ professionals, that’s something which they have a lot of experience in. So that’s something we definitely suggest to them is to make sure that they have the financing in place.
Richard: Yeah. No, absolutely. I agree with you completely on that point, Jeffrey.
Jeffrey: Now, at the time we’re recording this, it’s Tuesday, July 11. The Bank of Canada is meeting, and the speculation is that the bank will raise interest rates for the first time in a number of years. Richard, what is the forecast as you see it for financing, as well as for the mortgage market?
Richard: Well, an increase, I think the Bank of Canada… This is the first time in I think approximately seven years that the Bank of Canada has looked at raising rates or the potential for a rate raise. There’s mixed signals in the market. There’s a few reports out that are saying that it won’t actually cause much of a slowdown. The building permits issuer this morning, I think I saw it on this morning’s news, that they’re still strong. Construction is still vibrant. So now, that might be some lag that obviously construction products obviously have to get to the point where they’re taking a permit out. They’re already well along in the process.
I guess, the next two or three months will tell if permit requests start to drop off. But I think for this foreseeable future, the committed projects will go ahead. People may evaluate if and when the rate hike takes effect. I think the other experts are saying there’s already a little lag in the market right now. There’s definitely a feeling of a slowdown in the last I would say six to eight weeks. We may see a little more of a slowdown in certain market segments, perhaps at higher-end properties. But there’s still a tremendous influx of people wanting to live in the downtown core, and we believe prices are going to remain stable.
Jeffrey: Yeah. I talked to a real estate agent a number of weeks ago, and he echoed those sentiments. Basically, for quality properties, there will still be a demand. The velocity of properties, in terms of they may be on the market a bit longer, but it’s really all about pricing now. The frantic bidding wars that we saw back in the winter and spring are for a large amount of properties dissipating now. So buyers are getting a little bit more savvy. They’re getting more for their dollar, and sellers are being more realistic, hopefully, about pricing of what things are actually worth.
Richard: Yes. No. I agree with that sentiment completely. In fact, it’s a natural development and progress in our real estate market for ebbs and tides, both in supply and demand. Probably, the bubble that they refer to that everyone is concerned will burst, I’m not sure that it’s going to be a burst more than a slight deflation in demand with an increase in supply. But again, we’re not forecasting much of a drop in good properties in prime locations.
Jeffrey: Well, Richard, we’ve covered a lot of ground in our chat today. I really want to thank you for your time. If listeners want to get a hold of you, what’s the best way for them to contact you?
Richard: The best way to contact me, I take calls directly on my phone, which is 416-571-5700. Or alternatively, my email address is email@example.com. Folks are welcome to visit our website at lenderdirect.ca.
Jeffrey: Fantastic. I’ll put that in the description below. Again, thank you for coming on. I really appreciate the wealth of information that you shared today.
Richard: Thank you, Jeffrey. We’ll talk soon. Bye, now.