Commercial real estate lenders like commercial properties as investments—after all, it’s the whole reason they lend money for you to purchase deals! However, like any good investor, lenders like to mitigate their risk by limiting the amount of money they lend on any given deal to protect their own financial interest. Given the fact that they want to responsibly limit their risk, lenders will not provide you with 100% of the funding you need to purchase a property. Instead, they’ll lend you the majority of the total cost of the project, but expect you (or your real estate syndication) to provide a substantial down payment that typically ranges from 15% to 30% depending on the loan type, size of the loan, the life of the loan, and the lender.
Lenders require a significant down payment for two primary reasons:
- They want to ensure you (the borrower) have a financial stake in the deal’s success
- They want to account for any changes (primarily dips) in the property’s value throughout the course of the loan
The Loan-to-Value ratio (also known as LTV) and the Loan-to-Cost ratio (also known as LTC) are two indicators that lenders use to set limits on the amount they’re willing to lend you for a deal. Prior to lending capital for your commercial real estate project, your mortgage lender will first determine the level of risk involved using one of these two methods. Therefore, these real estate calculations are frequently used to determine how much money the lender is willing to loan you.
Since LTV and LTC are used for a similar purpose at a similar stage in the deal process, many new investors use the loan-to-value and loan-to-cost terms interchangeably. While these two indicators are similar in some ways, they are not interchangeable because they calculate slightly different things and are used in different contexts so it’s important to understand both.
In this article, we’ll explore each formula individually and then compare them side-by-side.
What is the Loan To Cost Ratio?
Loan To Cost (LTC) ratio is a simple formula that compares the Loan Amount to the value of the Total Project Cost in order to help lenders determine how much money they’re willing to lend. To calculate the Loan to Cost ratio, simply divide the Loan Amount by the Total Project Cost.
Loan to Cost = Loan Amount / Total Project Cost
In this equation, the loan amount is the total loan balance, and the total project cost is the total amount of money the investor(s) will be spending on the project. The reason that “project cost” is the term used is because LTC is most useful for construction loans that involve some uncertainty and greater risk about a property’s completed value.
Since LTC relies on project cost rather than the value of the property once it’s completed, the Loan to Cost ratio is more commonly used for lenders to assess development deals for a construction loan.
The amount that a lender is willing to loan depends heavily on the lender, type of property, location, track record of the borrower, and the relationship between the lender and the borrower. If the lender has worked with the borrower on 15 similar deals previously, and they’ve all gone well, the lender may be more likely to provide a higher LTC ratio that requires less equity from the borrower and provide better terms. If the lender has never worked with the borrower, they may feel like the deal naturally comes with higher risk since they’re unfamiliar with the borrower’s track record and may be more likely to go with a lower LTC ratio than they would to a borrower who is new to them and doesn’t have as strong of a track record. Why? Because the LTC ratio is all about helping the lender understand and mitigate their financial risk.
An Example of Loan to Cost Ratio
Let’s say that a developer is searching for a commercial real estate lender for a $1,000,000 development project. Based on the market conditions, type of building, location, and track record of the borrower (investor(s)), the lender is feeling confident they’ll get their money back and offer an LTC of 80%, or $800,000. Since there are 20% or $200,000 in unaccounted funds for the $1M property, it requires the borrower to contribute $200,000 of their own money to the project in the form of a down payment.
What is Loan To Value?
The Loan to Value (LTV) Ratio is a simple formula that compares the loan amount against the property’s market value. By evaluating at the loan amount and the property’s market value, LTV allows investors and lenders to measure how much leverage is used in a deal.
The LTV ratio is largely used as an indicator of lending risk. Low LTV loan assessments are typically seen as lower-risk loans, whereas high LTV loan assessments are typically seen as higher-risk loans.
Loan To Value = Loan Amount / Property Value
In this equation, the loan amount is the total loan balance, and the property value is the amount of money that a third-party appraiser determines the property is worth. Since LTV relies on property value rather than project cost, the Loan to Value ratio is more commonly used for lenders to assess acquisition deals as opposed to development deals.
Since ground-up development projects can take years to complete, it’s extremely difficult to accurately predict the completed value of a new project which is why LTC is more commonly used for a large construction projects. However, if an LTV ratio is needed for a construction project, the appraiser will draft a pro forma and estimate the worth of the property “as complete.” Be aware, though, that this approach is frequently inaccurate because the market conditions can change dramatically by the time the building is complete, the construction company can run into supply chain issues that may alter the final look/feel of the building, etc.
Just like with LTC ratio, the amount a lender is willing to provide depends on the amount of risk they see in the deal. Depending on the type of property, the amount of the loan, the lender, and the area, different loan-to-value percentages are offered by different lenders. 75% is typically a good LTV and common enough that investors who are forecasting numbers on a deal can use to determine their maximum loan amount. However, LTV ratios can vary; a triple net lease property may have a higher LTV ratio at 90%, whereas a land loan may have a lower LTV ratio of 50%. The down payment requested from the borrower is the difference between the value and the loan amount.
An Example of Loan To Value
Let’s say that a group of real estate investors want to purchase a property that is already built. The appraised value of the property is $2,000,000 in its current condition, and the investors (borrowers) apply for a loan to finance the property. Since the lender likes the market conditions, location of the building, and the investors’ plans for the property, the lender agrees to provide a maximum LTV of 80%, which means the investors need to provide the remaining 20% (or $400,000) as a down payment/equity.
LTV vs. LTC: What’s the Difference?
Loan to Value (LTV) and Loan to Cost (LTC) are both formulas used in commercial real estate investing that help lenders determine how much money they’re willing to loan on a deal. The biggest difference between the two is that LTV compares the loan amount to the appraised value of the property, whereas LTC compares the loan amount to the cost of the project. Because of this, LTV is more accurate with acquisitions of existing buildings, and LTC is more accurate with the funding of new development.
LTV vs. LTC: Which is Better?
The word “better” in commercial real estate can be subjective and highly dependent on the situation, and determining whether LTV or LTC is better for a particular deal is definitely one of those situations. As a result, commercial real estate lenders may compute both the LTV and LTC ratios and select the one that they feel more comfortable with, given the property, timeline, market conditions, etc. For example, let’s look at how the LTV and LTC may differ on the same hypothetical deal.
Let’s say that a group of investors who are experienced with real estate projects want to build a new office building from the ground up. The investors estimate a two-year timeline and construction costs of $2,000,000, but when the building is complete, they estimate the appraisal value will be $2,500,000. The lender has a maximum loan-to-value ratio of 75% and a maximum loan-to-cost ratio of 75%. You’ll notice both percentages are the same, but they have very different outcomes in regard to the amount of money that is loaned.
Loan-to-Value: $2,500,000 * 75% = $1,875,000
Loan-to-Cost: $2,000,000 * 75%= $1,500,000
As you can see, the maximum LTC generates a lower loan amount and comes with a bit less risk because the lender doesn’t need to estimate the final appraisal value of the building two years in the future. Therefore, in this situation, the lender would likely use the LTC ratio to determine how much they’re willing to lend.
Now, if the building is already complete and a group of investors approaches the same lender with a simpler acquisition deal, the lender will likely just look at the LTV ratio since the LTC ratio isn’t as relevant in that situation.
Summary
Using the LTV and LTC ratios is one of the best ways lenders determine the value of the loan and the amount of equity they expect the borrower to have in the deal. Understanding how lenders use these ratios will help you improve your underwriting skills as well as the way you approach deal structures.
Despite the similarities between the two measuring devices, LTC is better suited to assessing the “skin in the game” equity that a borrower contributes to a project, whereas LTV is a better gauge of the project’s overall value, particularly when building may be necessary. Both are important to consider when applying for loans or making purchasing decisions since lenders typically use them to assess risk.
