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The reason why financial institutions generally retain the economic value to finance your rental building

The reason why financial institutions generally retain the economic value to finance your rental building

Several owners of buildings with rental residences (of 20 apartments and less) wonder about the variation that exists between the commercial value of their property and the value used by the financial institutions to authorize a mortgage loan. Indeed, at the time of a mortgage refinancing or acquisition of a rental building, the value considered by the institutions is sometimes lower than the commercial value. Several owners or potential buyers probably experienced this situation during the last few years.

 

If, for example, the financial institution requires a minimal deposit of funds of 25% of the value of your property, it is extremely probable that, actually, you will have to grant a percentage of the deposit of funds superior to the one under consideration at the beginning. This situation is explained by the fact that the value considered by the lender is not the commercial value of your property but rather its economic value.

 

But what is the economic value and which are the factors that condition it?

 

The economic value is defined as being a value mainly determined by two variables: an average of the historical outputs required for revenue creating buildings and anticipations in the medium term relating to the real-estate market. In our jargon, the yields required are better known under the name of “global rate of actualization” or “GRA”.

 

The GRA is mainly influenced by the expected outputs of the investors, the conditions of financing and the interest rates imposed by the market. Given the convulsive movements of the financial markets during the last few years and the weak mortgage rates, we observe that, at present, the GRA raised on the market (or its equivalent) is definitely lower than what we have been able to observe, on average, historically. Consequently, the commercial value tends to be higher than the economic value. Indeed, the more the yield required on net incomes is weak, the more the commercial value of the building tends to increase, and this, anything else being, in addition, equal.

 

Moreover, financial institutions generally use standardized scales of expenditure in order to determine the economic value of rental buildings. These scales come from statistics on the market and reflect the average level of expenditure for a building, over a period of a few years. The standardized expenditure includes the administrative expenses, wages, expenses relating to maintenance and repairs and reserves concerning movable property.

 

Each financial institution has its own scales of standardized expenditure and its own conditions of financing which, combined with the use of an “economic” GRA, explain the variation observed between the commercial value and the economic value of a residential building.

 

During the last few years, we have observed that, in the majority of the markets of rental buildings, there was an imbalance between supply and demand. Indeed, demand was higher than supply, and this, mainly on the resale market. As much and as long as this situation will continue to exist, we can expect that the difference between the commercial values and the economic ones persists.

 

In conclusion, do not be surprised if your financial institution announces you that it cannot lend to you according to the commercial value of your rental building. It acts as such in order to be protected and, especially, to protect you against unforeseen occurrences. In case of a significant increase of the interest rates, the commercial value of your property could decrease and your monthly mortgage payments… increase.

 

We propose to you an update of the situation so that you can understand the remarks of this article

About the author

É.A. Évaluateur agréé Yannick Lemelin

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