The conversations many Canadian residential developers are having with financial institutions sound much different now than they did six to eight months ago. It is safe to say that banks are regaining their appetite for builder and developer financing. Now more than ever, though, developers must have a solid relationship with financial institutions and a track record of impeccable performance.

During 2008 and much of 2009, Canadian financial institutions bunkered down like their global compatriots, losing any craving for builder and developer financing. Some U.S. institutions that were active in Canada retreated south of the border to deal with their own domestic difficulties. The surprisingly short-lived downturn of the Canadian housing market, combined with its robust recovery, helped to limit the banks’ downside damage, reducing expected write-downs as closings continued to occur.

According to bank sources, the builder and developer financing segment is again strong and solid and currently stands as a profitable part of their business. But has the “shock and awe” of the financial crisis created a new landscape for developers to navigate?

During the darkest days, even prime, low-rise green-field development often required proof of bona fide “end-user purchaser” pre-sales for financing to proceed. Financial institutions across the board had little to no tolerance for market risk. As conditions improved, banks were looking to come back into the industry selectively, essentially hand-choosing customers. By the third and fourth quarters of 2009, banks in Canada developed a growing hunger for residential project financing — mirroring the timing of the improving conditions in the real estate market. By early 2010, the financing freeze in most Canadian markets had fully thawed and dollars were again flowing into residential projects.

Currently, banks are indicating that low-rise projects in many markets generally no longer require end-user purchaser pre-sales, providing that supply stats and absorption rates all make sense. Add to the mix that interest rates, while on the rise, still remain historically low, and it appears that financial institutions are back in the game.

Mind you, the rules of the game have changed a bit, according to many developers.

A Tougher Playing Field

During the financing hiatus, there was an ever-increasing need for solid relationships between residential developers and financial institutions, and the current financing market is heavily relationship-based, leaving new borrowers struggling. Without a previous relationship with a financial institution, it is difficult or impossible to put a deal together, and more than a few new borrowers have been swiftly turned away.

Even developers with a proven track record are reporting a variety of challenges. In the low-rise segment of the market, it may be possible to obtain financing for up to 50 percent of the value on draft-plan-approved land. Draft-approved land and onward is also stimulating increased activity in brokerage and private funding, but these sources come with a heavy price tag: usually double the interest rate of financial institutions. Several institutions won’t even look at longer term land deals — such as land that is one to two years away from draft plan approval — leaving developers to seek out private funds or alternative financing means for those opportunities. This is also causing some developers to consider creating their own source of financing through the formation of mortgage development corporations.

A Revised Score Card

As for ratios and tests, banks report that loan-to-value ratios, equity participation ratios, and pre-sales tests are running similar to pre-recession requirements, but many developers believe otherwise. While it may be true that the bar is set at a level similar to that of pre-recession times, it is more likely that there is no longer any “bend in the bar.” It is a much more “by the book” financing climate, where scrutiny is the order of the day. For low-rise, green-field developers to obtain service financing, proof of 50 to 60 percent pre-sales to bona fide builders with “agreement of purchase and sale” contracts seems to be the norm. On the more extreme side, some of these projects are requiring 75 to 100 percent pre-sales if development servicing has more intense off-site infrastructure requirements, which is also becoming more common.

The High-Rise View

The high-rise developers are making adjustments to accommodate a new financing climate, as well. Project financing is typically requiring that developers have 20 to 25 percent equity, with a varying range of requirements for the use of deposits. Some developers report that construction financing previously available at a 65 percent pre-construction sales level is now not available until 70 percent sold — with up to 80 percent pre-sale requirements for some projects. This impacts the price “pick-up” that these projects can typically garner after construction commences, which then directly impacts project revenues.

In addition, it is requiring more marketing time to generate these extra pre-construction sales, which creates increased expenses as sales offices and all related overhead must be utilized for an extended period of time. Ironically, this all falls at a time when the financial institutions want to see 12 to 15 percent profit level projections before they finance projects.

Even in the cases where the pre-sales ratios are at the most favourable levels for developers, the analysis of the pre-sales is tougher than ever, with many rejected. For pre-sales to qualify, developers can expect to provide the minimum purchaser deposit, along with a schedule of deposits to 25 percent, combined with documentation of proof on how a purchaser will be closing.

To further slow things down, many financial institutions are routinely requiring CMHC insurance on construction loans. While the CMHC method works well for the banks and their reserves, it usually creates delays in obtaining construction drawdowns for the developers. Another trend is for projects that are $50–$60 million and higher with loan requirements over the $30–$35 million range to be pieced-off among financial institutions to minimize project exposure. Meanwhile, other banks are simply “closing” financing as soon as their high-rise exposure is at their “designated” maximum level.

In an industry where time is money and delays mean missed opportunities, these extra hurdles can create significant challenges for developers.

Supply-Side Shortages & Market Impacts

Builders that relied heavily on spec inventory homes in their business models are still scrambling to find solutions, as spec financing has all but dried-up and is slow to re-emerge. For some builders, this is causing considerable revenue stress. Whereas their markets previously provided them with 30 to 40 percent of annual sales through spec inventory, banks are now barely interested in providing financing for one new spec home for every four sold from inventory.

A mix of faster market demands with slower financing approval is also contributing to a supply-side issue in some markets. For low-rise developers, a previous four to six week turnaround for financing approval may now take several months. This can often skew reports for housing starts and building permits in some regions, as numbers are down due to a lack of availability rather than market conditions. In addition, financing delays create missed market opportunities.

Other impacts that are further distorting industry reports have been created by building code and taxation changes. The building code change to make fire sprinklers mandatory for projects four storeys and higher in Ontario created a rush for project permits as developers hurried to avoid increased costs — costs that can add $4 to $5 per square foot to a project for this code change item. And the looming Harmonized Sales Tax (HST) in Ontario and British Columbia also brought forward a variety of projects that had been mothballed over the past 18 months. These factors have inflated starts, while not entirely “demand driven.”

Southern Exposure

While Canadian financial institutions seem hungry for residential project financing, it doesn’t appear that their cravings have them looking south of the border. As the financing market for U.S. residential acquisition and development continues to reel from the credit crisis, Canadian financial institutions don’t appear eager to extend their current “States-side” positions. Until there is a clearer indication that a “floor” has been established in the United States, it remains unlikely that Canadian banks will aggressively pursue additional U.S. business.

Looking Forward

Although the Canadian economy is exhibiting good signs of growth and recovery, the ongoing global uncertainty continues to necessitate caution. The recent economic meltdown was centred on the financial industry, and it is reasonable to expect that this industry will move slowly and act conservatively for the foreseeable future. Increased scrutiny, more detailed analysis, longer approval periods, and more stringent stress tests for projects are the new normal. Add to this mix that municipal letter of credit requirements are increasing — along with other security requirements — while costs for municipal capital items such as parks, bus shelters, roads and more are being increasingly shifted onto the backs of developers, and there is little room for error in the calculations between profit and peril for projects.

The financing freeze for residential development in Canada appears to have thawed; however, do not expect the floodgates to open anytime soon. The financial crisis was severe and its effects will be long-lasting for the worldwide banking industry. Fortunately, the Canadian residential development market appears to be exhibiting strong signs of post-traumatic growth, and financial institutions have come back to the table with a cautious appetite to do business again.

Tim Bailey is general manager of AVID Canada, the leading provider of customer loyalty research and consulting to the home-building industry. Through the AVID system, home builders improve referrals, reduce warranty costs, and strengthen their brands. He can be reached at tim.bailey@avidglobal.ca