Given the numerous construction deals that our office has seen over the past half year, I thought I would provide some details on how construction mortgages work with particular focus on the concept of “cost to complete”. Banks and lenders use two primary ways to determine their exposure on a construction deal. One method is referred to as Loan to Value and the other method is referred to as Loan to Cost. They may sound the same but they are significantly different and can change the entire risk profile of a deal in the eyes of a bank or lender.
Loan to Value refers to the percentage of a property that is financed by a mortgage. For example, 75% loan to value means that for a property worth $100 there is a mortgage for $75 on the property and that the borrower has equity in the property of $25. Loan to Cost refers to the percentage of the cost of a property that will be financed by a mortgage. For example, 65% Loan to Cost means that if a property is going to cost $100 to construct a mortgage for $65 will be provided and the borrower will require $35. Value and cost are not the same thing. Value refers to what the market is willing to pay for something based on comparable prices whereas cost refers to what something costs to deliver to the market.
Consider the following example. A builder says “I can build a property and it will be worth $750,000 once completed and I am looking for a mortgage equal to 75% of the value or $562,500”. This may seem like a good deal given that the borrower should have equity in the property of $187,500 ($750,000 value less mortgage of $562,500) however there is a key piece of missing information – what was the cost to the builder of constructing the property? What if the cost to the builder was only $500,000? This would mean that a mortgage of $562,500 is $62,500 more than the cost and that the builder actually has no money in the deal. If the builder has no money in the deal it will be difficult to get the builder to finish the project if anything goes wrong. This is because the builder does not have anything at risk to protect. If the same example was done on a cost basis, the builder would have to put in cash of $125,000 ($500,000 cost minus $375,000 or 75% of cost). If the builder had $125,000 to lose their motivation to work through any problems or issues that arise is greater than if they had $0 at risk and only their time.
If you are considering a construction mortgage make sure you know the amount of the mortgage you need as banks and lenders all evaluate costs differently. Some banks and lenders will only finance the costs associated with the land and the materials and not general contractor fees, legal fees, appraisals, architects, etc.
“The road to success is always under construction” – Lily Tomlin
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