Imagine that as a developer you have convinced a lender of the strength of your vision. You have provided a detailed feasibility study that shows great returns are possible. You have developed a detailed construction budget to show that costs are under control. The lender is as excited as you are to get this project built. What happens next?
Looking over your shoulder
Be prepared for an ongoing relationship with your lender. A new apartment building will require roughly 25% equity before a lender will approve a loan. For a $30- million building, that’s roughly $7.5 million a developer has to put forward. This investment from the developer can include the current value of the land (which can be more than the price a developer paid for the land).
Once developers provide a construction budget that lenders will accept, with costs comparable to industry standards, the lender will advance money based on the costs in place and the cost required to complete the project. The lender will distribute the money in stages to ensure he or she doesn’t end up committing more than has been built. These advances are often reviewed by a quantity surveyor or a project monitor who oversees the project and advances money on a schedule after satisfying themselves the costs in place are occurring according to schedule. The cost of this professional is paid by the developer.
It is at this stage where projects can run into difficulty. This is why it is important to keep costs under control. If construction costs get out of control, the developer, not the lender, will be expected to inject any additional funds.
Changing from construction financing to permanent financing
Once your project is substantially complete, the time comes for construction financing to be replaced by permanent financing. This usually occurs when rental income reaches 75% of the projected gross revenue of the building. When 75% of the construction is done, and units are being rented, a construction lender considers the building done.
At this point the developer has a decision to make. Does he or she continue working with the construction lender? Or does he or she arrange take-out financing? The decision will depend on whether there is an alternate lender that would be more suitable at this stage. An experienced commercial mortgage broker might assess your market options and offer a better deal on your final equity requirements, which would improve the developer’s subsequent rate of return on his or her investment.
Because a new apartment project has no history and much perceived performance risk, the equity required includes a number of personal guarantees from the developer and the potential investor partners. These people must be prepared for covenant support for the project – they need to put their names behind their money.
No developer is getting unsecured financing in today’s economy. The lenders want the developer to have “skin in the game” to ensure the success of the project through the construction phase until there is a sufficient occupancy level to provide a return on their investment.
In the buildings that are being built, the developers have analyzed the risk and looked at the reward and have established confidence they will succeed in building and filling the units.
Derek Lobo is the founder and CEO of SVN Rock Advisors Inc., a real estate brokerage with over 30 years of experience in helping investors make the most out of buying, selling, and renovating purpose-built apartment buildings. Learn more about SVN Rock Advisors Inc., Brokerage on their website at www.SVNRock.ca.