When it comes to land development and construction projects everything largely comes down to the numbers — an equation of cost, interest rates, spreads, sales and profit. The planning phase is vital even for experienced builders, from securing funds to ensuring financial contingencies for project delays or shortfalls. For smaller or less-established developers, some of the critical questions our firm encounters can come during this phase, when determining cash inflows and requirements, or when evaluating a project business plan through the eyes of a lender.
Financing and cash flow are the lifeblood of any project, and while the industry has been enjoying strong performance in recent years, it is also being impacted by a number of mitigating factors, from tightened lending rules and regulatory pressures to evolving tax legislation. How are these factors impacting available credit, risk and rates for all developers? Are there new trends in financing, and do they have implications for traditional lenders?
Appetite for risk
To help answer some of these questions, I spoke with Carl Lavoie, vice-president of Debt and Structured Finance at CBRE Limited, for his insider perspective. According to Lavoie, lenders’ attitudes are changing and they are becoming a bit more risk averse. This is not a case of oversupply in the market but a combined effect of several factors:
- Ratings agencies: The industry is being subjected to regulatory pressures, from the recent Home Trust situation and the downgrading of Canadian banks;
- Rent Controls: Ontario government regulations with regard to rent increase/control are giving developers pause about rental stock given the decreased chance of profit, especially if interest rates go up;
- NAFTA: While the impact of discussions is still unknown, there have already been layoffs in Québec lumber industry;
- Immigration: What are Canadians’ attitudes, do we allow more or less? How will this impact future demand?
However, some developers aren’t necessarily feeling an impact, despite the recent turmoil. “There is still ample money available for established developers and quality, well-thought out projects, whether commercial or residential,” says Lavoie. “Lenders are just becoming pickier about where the money is going.”
Much of it is also a function of location and pre-leasing. If you’re a commercial developer who is 80 per cent pre-leased and have national anchor tenants, securing funds won’t be an issue. But if you want to put shovel in the ground on speculative construction, or if you’re in a marginal area, on a side street with little or no exposure and no-name retailers, you’ll need cash on hand as it’s unlikely you’ll get financing. The higher quality projects will have a better chance of getting debt at reasonable rates.
This may come as no surprise, perhaps. But from experience with some of my own clients, that doesn’t mean there aren’t options available for smaller builders, or those with more marginal projects. In this case, they may get a smaller loan amount and/or a higher interest rate, which will impact calculations on profitability. They may either need to self-fund the shortfall of the loan, or take a non-traditional approach.
At this point, as a borrower you have several considerations. If supplying your own funding, will it come from your personal savings and/or personal line of credit? Do you have another business with surplus funds that can be used? If you have the cash to purchase the land, can enough funding be obtained to see it through to completion? Capital required for zoning changes, development plans, construction costs, neighbouring disputes, delays, and so on, must be estimated. Your accountant can help establish cash inflows from operations or other companies, potential sale of assets, personal sources if required and, based on all this, estimate the loan amount to determine whether you have sufficient cash. If not, they can also help determine whether to move forward with the project or seek out alternative lenders, and connect you with contacts they may already have.
Rates and spread
It’s harder to predict where interest rates are headed, though warnings of an eventual increase by the Bank of Canada have been consistent. Most borrowers are on a floating rate, with terms dependent on the length of the project. Many developers usually have loans on a “bank prime plus” basis, with a current spread anywhere between 0.5 per cent and 2.5 per cent, based on the quality of the project, past success rate of the project/developer, etc. The biggest developers with plenty of proven experience, however, will attract lower BA (Bankers’ Acceptance) or CDOR rates, which currently range from 0.9 per cent to 1.5 per cent, with a 2 per cent spread.
There are, of course, other factors that impact pricing and debt. For condo developers, for example, what will drive rates is the pre-sale level, where you are on timing of the project, zoning, etc. If you are ready for shovel in the ground, with pre-sales of 75-80 per cent and structured deposits of 25 per cent, financing shouldn’t be an issue.
It’s important to note that access to funding is also a function of finding the lender that has the appetite on that particular day. There are a number of projects being built and at any given time some are coming to fruition, resulting in available capital looking for a new worthwhile investment. And what are the best projects developers should be focusing on in 2017? According to a 2016 study by Pricewaterhouse Coopers, they include industrial property, urban mixed-use and seniors’ housing.
Trends in financing
While many borrowers use ‘traditional’ sources — technically, only banks and credit unions regulated by OSFI (Office of the Superintendent of Financial Institutions) are considered traditional lenders — today there is a large pool of non-traditional financing available. This includes money from mortgage investment funds, public or private companies, pension funds and residential or commercial REITs. These entities are looking for higher returns than what traditional banks offer and are entering this market with the intention that land security limits their risk while offering a much greater reward.
An increasingly popular alternate lending scenario, according to Lavoie, is A/B structures or syndicated lending. For example, a borrower would have 65 per cent of the cost with an A lender, and 10-15 per cent with a higher rate B lender. On an average type loan, this can work out to a fairly reasonable cost. However this structure is done primarily with corporate lenders who expect higher returns, in the range of 8-13 per cent for riskier projects.
A new and still rare source of project funding is crowdsourcing, but Lavoie doesn’t see it impacting traditional lenders, nor is it something they want to get involved with. “If more of these are done they will become heavily scrutinized by the securities industry, and by the Office of the Registrar of Mortgage Brokers. There’s already enough oversight in our industry.”
The bottom line is that capital is available for quality developers or projects of any size, provided you plan for it appropriately and your numbers work. The higher the quality, the more capital is available at a lower interest rate, and with less effort required. Otherwise, be prepared to lower the risk for the lender with increased self-funding, or accept a higher interest rate, which can affect your rate of return.
Mahyar K. Hansotia, MBA, CFA, CPA, CA, is president of Sobel and Company, Professional Corporation, which is focused on business owners of small- to mid-sized companies, as well as large corporations, who are looking for financial acumen and strategic business expertise over and above traditional chartered professional accountant services.
Mahyar K. Hansotia