Whether you’re looking to update an existing property or start from scratch with new construction, securing financing is crucial before celebrating a real estate purchase. And while there are multiple factors that can affect loan terms, your loan-to-value (LTV) and loan-to-cost (LTC) ratios are important metrics to keep in mind. Let’s explore what LTV and LTC ratios are, with examples, and how they’re used in real estate financing and construction loans.
Understanding Loan-to-Value (LTV) Ratios
When using loan-to-value ratios, lenders are referencing the assessed value of an existing property, which is used as collateral. That helps the lender lower their risk, as commercial builders usually use unfinished collateral to secure construction loans.
Simply, lenders take the loan amount compared to the projected value of the property at the time of construction completion in the future. A lower loan-to-value ratio signifies lower risk.
- Formula: (Loan Amount / Appraised Value of Asset) * 100
- Example: An $800,000 loan on a building appraised at $1,000,000 results in an 80% loan-to-value ratio.
One thing to keep in mind is the assessment is for the property after the construction has been completed. If you were putting $100,000 into a building, but it increases the value by $150,000, that’s not only a strong investment, but it will help lower LTV ratio, too.
Lenders have differing limits in terms of how high an LTV they’ll accept, with 80% being an upper limit for some conventional financiers.
Exploring Loan-to-Cost (LTC) Ratio
Similar to an LTV ratio but with some key differences, is a loan-to-cost ratio. Instead of using the property’s value after construction, this equation uses the projected cost of the completed project. This includes total acquisition or development expenses, including construction, land, and other expenses. And LTC is decisive for construction loans and new developments.
- Formula: (Loan Amount / Total Project expenditure) * 100
- Example: An $800,000 loan for a $900,000 project results in an 89% loan-to-cost ratio.
Lenders are typically looking for a lower loan-to-cost ratio, because there is less risk associated with a lower LTC. A lower LTC means borrowers are more heavily invested in the project personally. That means they’re less likely to not see it through to completion, and ultimately pay back the loan. Lower LTV and LTC ratios often mean better loan terms.
Key Differences Between LTV and LTC
While both assess risk, LTV uses current market value. That is subject to change with market fluctuations. Meanwhile, LTC uses total project cost, reflecting the borrower’s investment. Understanding this difference is crucial for determining financing options and risks.
Practical Applications of LTV and LTC
Before taking out any substantial loan, understanding LTV and LTC is essential for borrowers. Investors use both ratios to assess investment viability. LTC is key for construction loans. LTV is crucial for mortgage approvals and terms, but can also be used for construction loans.
Illustrative Examples of LTV and LTC
Let’s examine practical examples:
- LTC Example: A $27 million commercial property development project receives a $21.6 million loan. The LTC is 80% ($21.6 million / $27 million), meaning the borrower contributes 20% equity ($5.4 million).
- LTV Example: A $1.5 million property (appraised at $1.8 million) receives a $1.2 million loan, resulting in a 67% LTV ($1.2 million / $1.8 million).
Impact of Market Conditions on LTV and LTC
Something to keep in mind is that market conditions will affect LTV and LTC ratios. Rising property values lower LTV, while declining values increase it. If the property is consistently increasing in value, waiting a few months before seeking financing will lower the LTV and result in better terms. Of course, if something unforeseen happens like a housing market crash, and the property value plummets, a borrower will likely be unable to secure financing.
For LTC, rising construction costs increase the total project cost and the ratio. So, keeping those in check for borrowers is key.
LTV and LTC Ratios in Different Loan Types
LTV is primarily for mortgages, including the determined loan amount, interest rate, and PMI, as well as home equity loans. LTC is primarily for construction loans, as it ties in the cost of the project as a major factor. Both are relevant for commercial real estate loans: LTV for property value, LTC for development projects. And, when there’s a tight market for credit, lenders will consider both ratios for construction loans.
Managing and Improving LTV and LTC Ratios
It’s important to keep in mind these ratios aren’t stagnant. They can be improved. You can manage LTV and LTC by increasing down payments (lowering LTV), improving credit scores (potentially improving loan terms), accurately estimating project costs (for LTC), and planning for unexpected expenses.
The Interplay of LTV, LTC, and Debt Service Coverage Ratio (DSCR)
While LTV and LTC focus on loan amounts, the debt service coverage ratio (DSCR) assesses repayment ability. The DSCR is another financial metric used to assess a borrower’s ability to repay their debt obligations. It compares their total income to their total debt service, including principal and interest payments. A higher DSCR indicates a greater capacity to cover debt, making them less risky to lenders and investors. This ratio is often used in commercial real estate, business lending, and even personal finance to evaluate creditworthiness and financial health. Lenders often consider all three ratios for a comprehensive financial assessment.
Before Borrowing, Consider LTV and LTC
LTV and LTC ratios are fundamental in real estate finance. LTV assesses loan amount relative to property value; LTC uses total project cost. These ratios impact loan eligibility, terms, and risk. Effective management benefits both borrowers and lenders. Understanding LTV and LTC ratios remains crucial in navigating real estate financing.
Reach out to our finance experts at GenWealth Capital Commercial today to learn more about our construction loans and how terms are calculated, or apply online now!