Construction Financing: Determining Loan-to-value and Exit Strategy

May 9, 2023

Key points:

  • A project’s loan-to-value takes into account the property’s as-is value, as-complete value, and the construction budget to determine its success.
  • The two typical exit strategies at the end of a construction project are qualifying for a take-out mortgage, or selling the property.
  • There are several scenarios that will affect the outcome of a construction mortgage.

The foundational elements of construction financing

In this video, I go over the two most important foundational elements that will determine how successful your construction financing project will be. These are the loan-to-value ratios and the exit strategy of the project.

Don’t feel like watching? Find the full transcript below!

Chris: [00:00:00] Building your home is no easy feat. And when it comes to securing construction financing, that adds just another layer of complexity to all the moving parts. And in this video, I want to simplify construction financing to the two most critical foundational elements that are going to determine the success or failure of your project. And those two elements are, number one, understanding the loan to value of the project. So the as-is value and the as-complete and the relative loan to value. And number two, the exit strategy.

Determining loan-to-value

Chris: [00:00:39] First, let’s talk about loan to value. I’m going to use a simple illustration whiteboard here to kind of teach the critical elements here. So to begin with, there are three numbers that really matter. There’s the as-is value of the property that you own or are going to buy to build this home. So let’s say it’s $1 million. Then there’s the as-complete value, which is after the house has been constructed at today’s value, this has to be appraised by an appraiser, but we would get the as-complete value, assuming that your dream home has already been completed and is standing today. So let’s say it’s $2 million. And then the third number, which is critical is the construction budget. So to get from as-is value to as-complete value, we have discussed with your contractor and we figured out that it’s going to cost $750,000.

The three loan-to-value financing scenarios

Chris: [00:01:34] Let’s review three possible scenarios here. So scenario one is called free and clear. So what it assumes is that your $1 million home does not have a mortgage against it. Either you bought it cash or you paid off your mortgage, but you have all the equity in the property. Now, what you should know about construction financing is that a construction mortgage lender will give you a maximum of 65 to 75% of the as-complete value. So in our scenario, if the as-complete value is $2 million, 75% of $2 million is $1.5 million of construction financing that would be made available. And so in a scenario like this, if we only need 750,000 to complete this project, we’ve got tons of construction financing and this scenario would look good on paper. No problem. Green checkmark.

Chris: [00:02:37] Let’s take a look at another scenario that is probably realistic for a lot of people. You may not own your home free and clear. There may be existing financing or if you’re buying a new property, you may need to finance a portion of that purchase. So in scenario two, let’s just assume that there is an existing mortgage of $700,000 against the property. Now you need 700 an additional $750,000 of construction financing for your construction budget. So in total, that’s $1.45 million of financing against this property. Again, the lender will lend up to 75% of the as complete value, in our case, $2 million. So we can get up to $1.5 million of of financing. We only need 1.45 million. So yeah, this scenario is going to work. Green checkmark. Off you go and start putting the shovels in the ground.

Chris: [00:03:40] The third and final scenario is a scenario that won’t work. So let’s assume that you have an existing mortgage of $800,000 on your $1 million home. You need $750,000 to complete the construction. And so in total, that is $1.55 million of financing required. Keeping in mind that the maximum loan to value is 85% of the as-complete value, which is 1.5 million. You cannot proceed because the financing that you require exceeds the maximum loan to value permissible by the construction financing. So this one gets a red X, do not pass go. This will not get off the ground.

Exit strategy

Chris: [00:04:27] Now that we’ve gone through those three scenarios to illustrate the importance of loan to value, we have to talk about the second of the critical fundamental elements, which is the exit strategy. Now let’s go back to our example. We’ve now built this beautiful $2 million home. We have outstanding financing of $1.5 million in construction financing. And that construction financing is expensive. It’s not intended to be the long term financing solution. So one of two things needs to happen. Either A, you have to arrange for a $1.5 million take out mortgage, and this is really important before you begin any project to establish that you can qualify at a bank or an A lender or whatever the lender is, that you can qualify for $1.5 million of financing before you even consider putting pen to paper on any type of construction project. And if you don’t qualify for that take out mortgage, then you will have to sell the property. So these are the two typical exit strategies that most construction mortgages have at the end.

Chris: [00:05:47] So to bring it all together, there are two things that should come to mind, and that is that you really need to be thinking about the end of this process because the financing that you get will be dependent on the as-complete value of the property. So we want to know what the property will be worth once it is complete. And the second thing is we want to know, will you qualify for the required take out mortgage to ensure that you can pay out the construction financing at the end of the project?

Need more help or information?

Chris: [00:06:22] Thank you so much for making it to the end of this video. I know it can be a little bit dry. Hopefully you found some value. If you did, please consider subscribing to the YouTube channel. I will be sharing a series of videos all about construction mortgage financing. And if you don’t want to miss, please subscribe. My name is Chris Molder. I am a Toronto mortgage broker. If you have any questions or concerns about how you can finance your dream home, please don’t hesitate to reach out. Bye for now.

If you’d like to discuss your mortgage, you can contact me here or schedule a convenient call time directly into my calendar below.