If you’re ready to start investing in commercial real estate, it’s important to do your research beforehand. Chances are good that you’ll need to seek outside funding, and in order to do this, you’ll need to understand Loan-to-Cost (LTC) and Loan-to-Value (LTV) metrics, what they mean, and how they can affect you as an investor. Here’s everything you need to know.
Loan-to-Cost Ratio
Loan-to-cost ratio is typically referred to as LTC, and it is a metric utilized to help lenders determine the absolute risk involved in providing you with funding. To do this, the LTC compares the financing of the project (the “loan”) with the overall cost of construction. Simply put, it allows lenders to determine whether it will be profitable for them to provide you with a loan based on the expected cost of renovating or building a property. If the expected cost of renovation or building is too high, the lender may not take on the risk. If the cost is low, the LTC helps in determining the amount of funding you may receive. The formula for discovering LTC is simply the loan amount divided by the overall construction cost.
Loan-to-Value Ratio
On the other hand, the loan-to-value (LTV) ratio is similar, but different in that it compares the amount required for financing the project (or “loan”) with the fair market value of the property. Many lenders use the LTV to determine the maximum amount they will lend for any specific property. For example, if a lender offers you up to 70% LTV for a property, and that property’s fair market value is $500,000, you can receive a loan for up to $350,000 – or 70% of the fair market value. The formula for figuring LTV is the loan amount divided by the fair market value.
Why LTC and LTV Matter
Lenders prefer borrowers to have some of their own equity at stake in projects like this, which is why real estate lending is often limited by LTC. You will often find financers offering up to 70% LTV or 75% LTC as part of their loan terms for transparency. It is important to note that LTV and LTC metrics are separate from your credit score, your income, or even your net worth. They are solely determined by the factors given above.
To put this into perspective, assume that that the construction costs of your project are $250,000. You will need to have some stake in this project, so the lender gives you a loan for $200,000 rather than the full amount. To determine LTC, simply divide $200,000 by $250,000 to come up with 0.8, or 80% LTC. On the other hand, if the fair market value of a property is $250,000 and your lender offers you a $200,000 loan, that’s 0.8, or 80% LTV. In both cases, the lender ensures you have some equity at stake, which helps to reduce the lender’s risk.
LTV and LTC are two quite common and important metrics that all real estate investors should understand. They help you determine how much funding you qualify for in every specific project based on the fair market value of the home or the full cost of construction.
