In its simplest form, the Loan to Value or “LTV” is the amount of the loan secured by a property divided by the value of the property. This LTV ratio is an important metric in the assessment of the financial risk of a property loan. In the event of a loan default, the lender can sell the property and use proceeds to repay the debt. But the lender must remain certain that sale proceeds would be sufficient to repay the loan.

Defining value is important but also rather subjective, especially before a sale is made. The Merriam Webster Definition of Fair Market Value is: “A price at which buyers and sellers both having reasonable knowledge of the property and being under no compulsion are willing to do business.” While this is a good definition, what happens if there is no one willing to buy the property? This doesn’t mean that the property isn’t worth anything; however, no buyer for the property means that there is no liquidity. Lenders often rely on appraisals to confirm property values, but appraisal valuations of illiquid properties are notoriously unreliable.

In financing a development project, one must ask how difficult it will be to sell a property at various stages in its development. Until the project is finished, the market will be limited only to those people that are able to complete the project.  There may be very few buyers in this category, so the property’s liquidity is affected. Lenders and borrowers alike need a clear plan to reach an exit point.  

In the property development sector, there are three main stages with different liquidity levels. The first is land held for redevelopment which often involves progressing through the entitlement process. Buyers of land at this stage are typically patient and wealthy.  They have long time horizons and use low financial leverage. This process can take a long time because of the unpredictability of the political process (for example, obtaining rezoning approvals through municipalities can take a long time). After entitlements are in place, they may wait still longer until there is market demand for the end-product. Given the way prices have grown in recent years, as hard as it may be to believe, housing is a cyclical market – it has down cycles too! The availability of debt for these purchases is limited because of the unknown time to completion and sale. Liquidity at this stage is relatively low.

Next is the pre-construction stage. At this point, municipal entitlements are in place or close to it, and the project may be draft plan approved. The property may or may not have site servicing in place, but if not, servicing costs are known. Builders driving pick-up trucks are on the look-out for these site-serviced lots, ones they can buy, build a home, and earn a profit. These entrepreneurial buyers have limited access to business and development loans, and often obtain them from the private capital markets. Their prime considerations is what the expected price and liquidity of their finished product will be. There are medium levels of liquidity at this stage in the project.

The final stage is the construction phase. Provided that we have a competent construction project team, and a clearly defined path to completion of the final product, the time to completion of construction of homes is in the nine-to-18-month range. Liquidity will be immediate upon completion of a home if, and as is often the case, the home has been pre-sold before construction started.  If this is not the case, then market forces of supply and demand will affect liquidity. Buyers are families looking for homes, and in Ontario, there is currently a shortage of supply. These buyers have ready access to low-cost institutional and CMHC-backed mortgages. At this stage, liquidity is relatively high, although highly sensitive to price and dependent upon the cycles of supply and demand.

Morrison Financial, especially in the current market environment, tends to lend in situations where we can be relatively certain about end-values based on the sale of a finished home. We are cautious lending against land unless we have a clearly defined timeline leading to its ultimate development and project completion. All our loan agreements involving projects require a sound business plan to arrive at the next liquidity point. Provided we have a clearly defined timeline and a good business plan, then a residual value approach can be an accurate way to arrive at a land value in a development project.  To arrive at an as-is land value, we would take the value of a completed home and subtract HST, construction hard and soft costs, financing costs, the project contingency, and an appropriate profit for the builder. This would result in an estimated value of the project lands.

In a construction loan, we use a slightly different formula with a slightly different name, Loan-to-Liquidation Value (LTLV).  LTLV is defined as the loan availability (equal to the amount advanced plus the cost to complete the project) plus deferred costs; divided by sales revenue net of HST less deposits used in the project. The LTLV formula allows the lender to monitor the financial leverage at every point during the term of the project.  The loan availability remains constant provided that, with each advance of the loan, cost to complete the project is reduced in lockstep.  Put another way, every dollar advanced must be the result of a one-dollar reduction in its cost to complete. Because certain costs may be deferred to after repayment of a loan, the lender must consider that these costs will be charged to the project in the event of an enforcement.  Accordingly, they are added to the numerator of the LTLV calculation. Residential home sales are subject to HST, so this amount must be deducted from the sale price. If purchaser deposits are used in the project, at the time of conveyance of the completed home, the purchaser advances the purchase price less deposits already made. While this calculation is somewhat more complicated than the LTV formula, it is more conservative and provides the lender with an accurate assessment of the financial risk inherent in a construction loan.

Questions or comments?

Graham Banks, CFA, is Senior Vice President, Morrison Financial Services and can be reached at

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