This Article Appears in our November 2001 Newsletter
Apartment Financing
The right loan deal can save you money,
increase leverage or
allow greater flexibility
By Dennis Aitken
If you are purchasing an apartment building you may be confused with, or not be aware of, the various financing options available. In addition, your particular situation may require certain loan structuring to accomplish such things as renovations, your specific investment goals, level of financing, or other special circumstances, further complicating your financing requirements.
In this article I hope to clarify some of your options and provide a basic comparison of the types of mortgage financing available through traditional financial institutions.
There are essentially two main types of mortgage financing currently being offered plus numerous variations of each. These are a conventional mortgage or a CMHC (Canada Mortgage and Housing Corporation) insured commercial mortgage.
Conventional mortgages are typically available for up to 75% of the purchase price, or current market value of the apartment property. The level of mortgage financing is dependant upon a number of factors such as the physical condition of the building, location of the property, the cash flow being generated to service the mortgage payments, and the financial strength of the borrower.
Conventional mortgages are offered with floating or fixed rates with a term of generally one to five years, with longer terms periodically being available. The maximum amortization period offered is 25 years. Lenders generally charge fees of ¼% to 1% of the loan amount for a conventional mortgage. CMHC insured mortgages are available at loan amounts as high as 85% of value through most Canadian financial institutions and are insured by the Government of Canada against any credit loss to the lender.
CMHC insured mortgages are typically offered with a fixed interest rate (floating rates are available but are not the norm), a term of five or ten years and an amortization period of up to 35 years.
The costs of a CMHC insured mortgage are the insurance premium, the application fee and any fees charged by the lender. For existing rental apartment buildings, the premiums range from 1.75% to 4.5% of the mortgage amount depending upon the level of financing required. The application fee is $150 per unit up to 100 units and $100 per unit in excess of 100 units, to a maximum of $50,000. Both the premium and fees can be added to the mortgage amount and amortized over the life of the mortgage.
CMHC advantages
A CMHC insured mortgage has the
following advantages over a conventional mortgage:
- Lower interest
rate.
- Higher leverage.
- Easier to renew or refinance.
As a result of the Government of Canada guarantee, a lender does not have to reserve any capital against possible future credit losses. This feature allows lenders to reduce their yield requirements and thus offer substantial savings to a borrower through reduced interest rates. These interest rate savings can be up to 1% below a conventional mortgage’s interest rate.
The interest savings offset the costs of setting up a CMHC mortgage in the first few years of the mortgage term and can be enjoyed for future mortgage renewals. For example, if the interest rate savings over a conventional mortgage is 1% and the CMHC insurance premium is 2%, it would only take the first two years of a five-year term mortgage to pay for the premium. The interest savings would then be enjoyed for the balance of the five-year term and for any future mortgage renewals.
Higher leverage is another advantage with a CMHC insured mortgage since a mortgage amount of up to 85% of the value is feasible. With a conventional first mortgage only 75% of value is available. Consequently, the return on the equity invested by the owner is enhanced by utilizing CMHC mortgage insurance.
Finally, the renewal, or refinancing, of a CMHC mortgage is considerably easier. A lender can automatically renew a CMHC insured mortgage provided the payment history is satisfactory. With a conventional loan a lender must re-evaluate the credit risk of the mortgage at renewal time. If it is determined the value of the property has decreased or if the lender no longer wishes to renew the mortgage, the lender can demand payment of the loan. In addition, during more difficult economic times, conventional mortgage lenders chose not to renew apartment mortgages, however, there were lenders who would still finance CMHC insured mortgages.
Conventional loans
For conventional mortgages the
main advantages over a CMHC insured mortgages are:
- More flexibility.
- Quicker approval time.
- Less costly for a short term mortgage.
Conventional mortgages are more flexible in situations such as completing renovations over two or more years, or when you wish to increase the mortgage to take out some of your equity that has built up in the property. For example, you may wish to purchase a building, complete renovations over the next several years, increase rents to market levels for the renovated suites and then increase the mortgage to cover all, or a portion, of your costs. With CMHC this scenario is typically only feasible if the renovations and rental increases are all completed within a one year time frame.
Another example is if your property’s value has significantly increased over the past five years and you wish to take out some equity to purchase another investment. With CMHC you would only be able to refinance the existing first mortgage plus any capital expenditures incurred over the previous 12 months.
The second advantage is approval times tend to be quicker with conventional loans since the extra step of obtaining CMHC’s approval is not required.
The final advantage of a conventional mortgage over a CMHC mortgage is they can be less costly for a shorter term. A conventional lender normally charges a fee of ¼% to 1% to process a conventional mortgage application, which is less than the CMHC insurance premiums. In our previous interest rate savings example, it would take two years to cover the CMHC insurance premium.
In general, if you are an investor who wishes to hold an apartment property for the medium or long term, a CMHC insured mortgage is typically your best option largely due to your ability to obtain significant interest savings for the life of the mortgage. If you are a short-term investor wishing to refinance or sell in the short term, a conventional mortgage is currently a better option.
Also be aware that there are numerous variations to structuring CMHC insured and conventional mortgages depending upon your particular situation. I have only been able to touch on a few in this article. Contact a knowledgeable real estate finance professional to assist you in determining your best alternative.
Dennis Aitken is Vice-President, Mortgages and Prairie Regional Manager for Peoples Trust, based in Calgary, Alberta. He can be reached
at (403) 237-8975.
