By David Franklin
In a 2004 paper asking for feedback from the mortgage industry, the Ontario Ministry of Finance stated: “Syndicated mortgages on commercial properties can be riskier investments than mortgages on single-family residential properties. The borrower’s ability to meet the mortgage payments may be more difficult for investors to evaluate. For example, the ability to pay may depend on the use of the property and the success of the borrower’s retail or commercial business. As well, syndicated mortgages may involve more complex legal structures and documentation. Investors have less direct control over the investment because they cannot act on their own to realize on the security of the investment.”
In other words, the Ministry of Finance was stating that development mortgages were not suitable investments for small investors because of their risk.
INVESTING DEVELOPMENT MORTGAGES RISKS
- If the development is not zoned, then there is the risk that it may not be rezoned and as a result there could be a loss.
- If the development is zoned and there is no building permit, then there could be changes required in order to obtain it and these changes could affect the profitability of the development.
- If there are not sufficient presales and/or preleases to obtain construction financing then then there could be a loss.
- If it takes longer than anticipated to obtain the necessary presales and/or preleasing for construction financing, the profitability could be affected.
- If there are negative changes to the economy, the banks may not provide the construction financing and this could cause a loss.
- If an alternative lender for the construction financing is found, then their costs and interest rate could affect profitability and if one cannot be found then there could be a loss.
- If during construction, there are delays or cost overruns, then this could affect profitability.
- If the purchasers or tenants have claims for deficiencies, then profitability could be affected.
- If the development is to take three to five years to complete, there could be negative changes to the economy, changes by the banks in their lending policies, changes by the government regulators on bank lending policies, increases in mortgage rates or amortization periods or changes to down payments back down from 20% to 25% as they were before 2007. If this happens, and we do not have a crystal ball to tell what these factors will be for three to five years out, then some of the purchasers and/or tenants may not be able to complete their transactions which could affect profitability or cause a loss.
- If the development requires an initial financing and then further financing over time, there is no guarantee that that the developer on whom the initial investors are basically completely relying upon, could find enough investors to fund the balance. If this happens then there could be a loss.
- If the investors are funding a first mortgage that will postpone construction financing, and the development does not proceed, there could be a loss.
- If the developer does not have their own resources to fund the interest payments to investors and the mortgage requires interest payments, part of the funds the investors are investing will be used to pay their interest and not be used for the actual funding of the development.
- If the investor expects to be repaid upon the maturity of the mortgage, the investor may not be repaid if the development is not completed by that time.
- If the mortgage is extended and the developer does not have the ability to fund the mortgage payments until the development is successfully completed, the investor will not receive the interest payments during this period.
- If the developer gets into financial trouble, there could be a loss.
In other words, development mortgages can be high risk investments.
OPINION OF VALUE
An appraisal sets out what the fair market value (FMV) is of a property as of a specific date and one of the most important components in determining FMV are market comparables. If there are no market comparables then the appraiser has to make assumptions as to what the FMV is. Determining how the appraiser comes to his FMV requires the investor to determine if he agrees with the assumptions.
An opinion of value can be issued by parties who are not appraisers. Opinions of value for development projects can be based on assuming what the end value will be, and this could be two to five years or more in the future. From this projected end value the following items are deducted: 1) construction costs, 2) management fees, 3) financing costs, 4) marketing costs, 5) sales commissions, 6) marketing costs, 7) building permit costs, 8) city, municipal or other government fees, 9) cost of presentation center, and 10) legal fees, etc. The residual value includes the land and the developer’s profit, not just the land value.
An opinion of value is a theoretical future value, and as you can surmise, not the FMV as an appraiser would determine value of the land as of a specific date.
RRSP AND TFSA QUALIFIED INVESTMENTS
The CRA requires mortgages to be qualified investments, with the loan to value, including any prior debt, not exceeding 100% of the FMV of the property as CRA determines it to be. Even if there is a current appraisal setting out the FMV, the CRA does not have to accept it and if it challenges the value, then the investor must take the appropriate steps to prove the CRA is wrong and that can be costly. Since appraisals can be off by about five percent, it would be wise not to lend to 100% of FMV but lend up to a maximum of 90%, allowing for at least a 10% leeway. Who would want to have to pay 50% of the amount invested for investing in a non-qualified mortgage? Can you imagine the pain if you lost money on the investment and had to pay the 50% tax as well?
The trust companies administering the self-administered plans put the onus on the investor to ensure that the mortgage is a qualified investment.
There can be great returns on these strategies but as an investor it is important to also consider the risks.
David Franklin, B.Comm, JD, has been practicing law in Ontario for over three decades, specializing in securities, mortgages, tax and real estate, and overseeing and transacting millions of dollars of transactions. Contact David at firstname.lastname@example.org.