A variety of loans are used in commercial real estate finance. Real estate investors’ projects and themselves both need to be risk-evaluated before they can borrow the money they require to finance them. Lenders will set stiffer conditions if there is more risk associated with the borrower or the project. LTC and LTV are relevant in this situation.
When choosing to borrow funds from a lender, it is vital to understand the difference between loan to value and loan to cost since it will determine the amount of loan the borrower would be able to apply for. Here is. a detailed overview of loan to value vs loan to cost and what does each of them mean when taking a loan.
Loan-to-Cost
To compare the funding amount with the cost of a project, the Loan-to-Cost (LTC) Ratio is determined by dividing the loan amount by the construction cost.
What is the meaning of the Loan-to-Cost ratio?
The LTC ratio is used to calculate how much or what proportion of a loan, based on construction expenses, the lender will grant for financing real estate projects. The project will be revalued after construction is finished.
The riskier the loan is for the lender, the greater the LTC ratio. Due to this, the majority of lenders have established LTC ratio restrictions for the sum of money they are ready to loan to finance a real estate project, with the majority of lenders capping this at 80% of the overall project cost. There are rare instances, though, where greater LTC funding is accompanied with a higher interest rate to offset the lender’s increased risk.
The valuation and the project’s location along with the loan and good credit of the prospective borrower, are all factors that lenders consider when deciding whether to issue a loan. The LTC ratio is only one of these factors.
The Importance of the Loan-to-Cost Ratio
Borrowers can determine how much money they will need to put up to finish a building or remodeling project using the loan-to-cost ratio. After determining the acceptable LTC, the lender can use it to determine how close they are to meeting their requirements and how much funding is necessary to make the loan eligible for underwriting.
Who Does Loan to Cost Metric Apply To
Borrowers who utilize these loans to buy, renovate, and then sell a property within 12 to 18 months are known as “fix-and-flip” borrowers.
Borrowers who renovate to become permanent: These borrowers are comparable to fix-and-flippers, but instead of selling the home, they turn the short-term loan into long-term finance to use the property as a rental property.
new borrowers for construction The LTC for a new build is calculated in this instance by comparing the costs of the ground-up building to the loan amount.
The lender will establish the highest LTC value (often 75%), that will inform customers of the loan’s high-end limit. Simply alter the method above to solve for the loan balance to determine the maximum loan amount required:
Loan-to-Value
The loan-to-value ratio (LTV) is the maximum value of an asset for which a lender will extend a loan. Typically, this is presented as a percentage.
“Desirable” assets typically have a higher LTV because lenders are willing to take a greater risk on them. The stability of an asset’s value, the liquidity of its secondary market, and the simplicity with which the title can be transferred to other parties are typical criteria for determining an asset’s suitability as collateral (among other things).
To gauge the level of risk associated with a secured loan, lenders look at the loan-to-value (LTV) ratio. It is a metric that evaluates how the principal loan amount compares to the current market value of the collateral used to secure the loan.
An example of a 50% LTV would be a loan that is 50% of the value of the underlying asset. Lenders bear the higher risk when LTV rises because of the greater loss they stand to incur if a borrower defaults on a loan.
Even though mortgages are the most prevalent type of secured loan for which the loan-to-value ratio is calculated, it is applicable to all secured loans. In fact, there are various government mortgage programs with strict LTV requirements.
How is Loan to Value Calculated?
Simplified, the formula is as follows:
The Loan-to-Value Ratio (LTV%) = (Loan Amount / Asset Value) * 100
However, in practice, there are a number of ways to compute or derive LTVs, depending on the premise being used. Several instances are listed below:
Adequate stockholders’ equity
To give an example, consider residential real estate.
For example, if you’re buying a house, your lender might insist that you put down at least 5% (or $0.05) of the total price. In that situation, the highest LTV allowed would be 95% (1-minus 0.05) times 100.
Absolute tolerance for danger
The financing needs of a business for factory machinery makes a useful case study.
In order to protect themselves, many commercial lenders may demand a safety net of sorts between the loan amount and the asset’s value. Maybe the bank’s risk team thinks they can easily sell the machinery at a discount of 25%.
This probably means they will not lend more than 75% LTV against the asset. You might think of it as 1 minus the “equity cushion.”
What Impact Does LTV Have on Monthly Payments?
In the United States, “risk-based pricing” refers to the custom of charging higher rates of interest on loans that are seen as more precarious than average. The same logic that results in higher interest rates for loans with larger LTVs also applies to credit scores: a higher LTV ratio indicates more risk to the lender, hence loans with such a ratio often come with higher interest rates.
Costs associated with a high LTV are not limited to increased interest rates.
Private mortgage insurance protects the lender from financial loss if you don’t pay back a traditional loan for more than 80% of the value of the home you’re buying. This is the case even if the loan itself is backed by a federal program. Private mortgage insurance premiums range from 0.5 percent to 1 percent of the loan balance annually and must be paid in full until the loan-to-value ratio reaches 78 percent. To refinance a $250,000 loan, for example, you can anticipate to pay an additional $104 to $208 monthly.
Loan to Cost vs Loan to Value
Lenders will frequently compute both the LTV and LTC ratios and pick the lesser of the two in order to better protect themselves. Take a look at an example to demonstrate this notion. Assume that an investor is looking for financing for real estate to build a new shopping complex. Estimated construction costs for the project amount $1,500,000. When finished, its estimated worth will be $2,000,000. The maximum loan-to-value is 75%, and the maximum loan-to-cost is 80%, as per the underwriting standards of the lender. The following calculation for the total loan amount will be governed by these two “constraints”:
Loan-to-Value: $1,500,000 ($2,000,000 x 75%)
Loan to Cost: 1,500,000 times 80%, or $1,200,000
These calculations demonstrate that the lower possible loan amount is produced by the loan to cost ratio. Because of this, the lender will set this as the loan’s maximum. From a risk mitigation perspective, this means that before loan repayment via collateral liquidation is threatened, the value of the property could decrease by up to $800,000, or 40%. This is a risk that many lenders are ready to accept.
Lenders will utilize LTV and LTC to underwrite a business and take risk loan variables into account. What distinguishes them from one another, and why should you choose one over the other?
The main distinction is apparent when you buy a house at a significant discount. Take the following case study of a request for a hard money loan on a mobile home park as an illustration:
Despite having a fair market worth of $160,000, Property A is bought for $100,000. Since the borrower does not provide enough of his own money, a loan for $80,000 for the purchase indicates a 80% loan to cost, which most lenders will try to avoid because it is high risk. However, the figure drops to 60% when considering loan to value, which is significantly closer to what lenders consider a secure investment.
The risk factors most lenders are looking for come under the loan to value framework, which could indicate a lower risk profile than a high loan to cost.
Final thoughts
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 hard money loans or making purchasing decisions since lenders typically use them to assess risk.