Give up the chase

First Source's Steven Walters explains why commercial brokers shouldn't expect their lenders to chase the market, despite its current heat

Give up the chase
Imagine this scenario: A developer has a site tied up for $3 million, purchased on paper just shy of two years ago and now ready to close. The appraisal was completed by a reputable firm and is valued today at $4.8 million ‘as is.’ The purchaser has completed a number of studies, has met with the city and is ready to make submissions for approval. The site now falls within the official plan, and the city wants it rezoned for higher-density residential development. The zoning approval will allow the purchaser to build his intended stacked townhouse development and increase the value substantially.

Closing is a month away, and the purchaser goes to his bridge lender for a 12-month loan, which should take him through the balance of submissions and eventually to an approval and exit with a construction lender. The purchaser brings his entire required document file to your meeting, along with the appraisal, and requests a loan representing 68% LTV.

Simple math places this loan at $3,264,000. Once you subtract legal and arranging fees of approximately $80,000, the purchaser is left with a loan of $3,184,000 on a $3 million purchase. (For the sake of simplicity, let’s assume costs to date are $184,000.)

How does a prudent lender analyze this?

On one hand, 68% LTV appears safe. Also, with zoning likely to be granted in six to eight months, the value of the land will only increase, further reducing risk.

However, the purchaser will have zero equity. All invested capital is being removed, so there will be no cash put in. The lender is basically purchasing the property and using the market lift or appraisal surplus to justify the transaction based on the equity of $1.8 million ($4.8 million – $3 million). Recall that other than some studies and actually tying up the property, nothing has been done to the property to increase the value of the site. The zoning is the same as it was a year and a half ago.

A lender who lends on this scenario is chasing the market. The purchaser will close his acquisition with no skin in the game. The market and the market alone is responsible for tremendous lift. It’s akin to saying that you started with a good idea a year and a half ago, that it was valuable then, but now that you’ve thought about it all this time, it has even greater value. Sound like hot air? It is.

However, there is a big difference in this case, which is that the change in land use to provide higher density is measurable. So, even though virtually nothing has been done to improve the land, the value per buildable square foot increases from the time the official plan changed and at various stages of development. Low interest rates, steady immigration and the limited supply of housing have also fuelled a tremendous increase in developable land value.

As we all know, an appraisal is a value assessed to a property at a specific moment in time. Unfortunately – or perhaps fortunately – these are unprecedented times. Commercial lenders should put far more onus on the purchase price rather than on appraised values. One must look carefully at comparable sales prior to deciding on the amount to lend and consider a cushion toward some kind of market correction.

Should the market take a drastic turn due to major changes in unemployment, increased interest rates or a catastrophic event that stops or drastically slows down the pace of demand for housing, land prices and real estate in general will decrease in value.

It’s been a long time since we heard the ‘r’ word: recession. However, sooner or later, this market has to lose steam. A commercial lender must be cautiously optimistic. In the present, we must remember lessons from the past to better understand our future.

I am not advocating that lenders stop lending until the market cools. Rather, I’m strongly suggesting not to get caught up in recent large increases in land values. Don’t chase the market – it’s not sustainable, and someone is going to get hurt.

Steven “Skip” Walters is the senior vice-president of business development at First Source Mortgage Corporation.