There are many different factors that lenders consider when evaluating financing for commercial real estate. Loan to Value is one of the most discussed terms in commercial real estate finance. To determine interest rates, loan terms, and overall risk, one common metric that’s used is the loan-to-value (LTV) ratio. It’s a simple calculation that can offer a lot of information for both investors and lender.
What is the Loan-to-Value (LTV) Ratio?
The LTV ratio is one of the methods lenders and financial institutions consider when assessing risk. It provides insight as to the level of risk that’s associated with each commercial real estate loan by evaluating the relationship between the loan amount and the current market value of the commercial property in question.
Simply put, the LTV ratio is the total debt on a subject, portfolio, or properties divided by the total value or purchase price of said properties. From a risk-premium perspective, traditionally the higher the loan-to-value ratio, the higher the interest rate. Lenders often seek higher LTV’s to be mitigated with other strengths such as strong cash flow or good post-closing liquidity in relation to the loan request. Therefore, borrowers with high LTVs with minimal liquidity may struggle to get commercial financing.
How to Calculate LTV
The loan-to-value ratio is calculated by dividing the current or request loan amount by the appraised or estimated value of the property. The formula is as follows:
For example, if a borrower is interested in financing a commercial property with an appraised value of $4,000,000 and they have $1,000,000 for a down payment, the LTV ratio would be 75% ($3,000,000 ÷ $4,000,000 = 0.75). Loan to Values around 75% are typically what most lenders will max out given their credit policies.
However, if the borrower had $2,000,000 for a down payment, the LTV would drop to 50% ($2,000,000 ÷ $4,000,000 = 0.5). This leverage is more appealing to lenders as it indicates a lower risk of default payments given the amount of “skin in the game” the borrower has provided.
Lenders calculate the LTV ratio during the original financing period. However, loan-to-value ratios can change throughout the repayment term. As a borrower makes loan payments on an amortized loan, the LTV ratio declines as portions of principal are repaid. This assumes asset values are appreciating. Subsequently, this means that if property values drop, the LTV ratio becomes higher. If at any point the LTV ratio is 100% or higher, the borrower is considered underwater, which could cause obstacles if looking to refinance or sell the property.
The Importance of LTV
LTV ratio calculations are one of the most important aspects of commercial mortgage underwriting for both lenders and investors. It’s important to lenders because it gives them an objective assessment of risk by gauging the amount of equity the borrower has invested. If they finance property that has high LTV ratios, it means that in the case of foreclosure or default payments, they’ll face a harder time selling the property at the amount needed to cover the outstanding balance. It becomes increasingly difficult to secure good rates for commercial real estate financing if LTV numbers are high. Since they determine a lender’s eligibility for commercial real estate financing and associated interest rates, putting down as much capital as possible can be helpful in securing more competitive interest rates and terms.
How is LTV Used by Lenders?
Lenders utilize the loan-to-value ratio as a way of both determining eligibility and risk. It allows them to get a better understanding of the borrower from a financial viewpoint. Many lenders look at the whole picture rather than solely LTV ratios to determine whether they’ll move forward with commercial financing. However, the lower the LTV ratio is, the more likely lenders are willing to lend to them.
How Does LTV Affect Interest Rates?
Many commercial lenders determine eligibility and interest rates based on the amount of risk a borrower demonstrates. Risk-based pricing is a common practice, which leads to higher interest rates for riskier loans. Risk is a cumulative calculation that considers many factors, but the most common metric is LTV. If the LTV is too high, lenders assume there is more risk and price accordingly.
What is an Ideal LTV?
A loan-to-value ratio of 75% or less is considered bankable for investment property financing. Every property, transaction, and borrower are different. Some property types have strong economics and lenders are more willing to extend more leverage, whereas other properties may be more special use and have lower LTV requirements. On average, an LTV less than 65% is considered very strong and can attract competitive pricing from the capital markets.
Understanding Combined LTV (CLTV)
A combined loan-to-value ratio is the ratio of all loans that were secured by one property divided by the current value of that property. This is calculated when borrowers need to take out more than one mortgage, including mezzanine financing, lines of credit, and other liens on a single property. CLTV is just another way lenders can assess risk. If the CTLV exceeds 85% most lenders may elect to not originate those loans.
Factors That Affect Loan-to-Value Ratio
There are a few ways that you can strategically lower your LTV ratio, but doing so may require either more time or an altered budget.
Size of Down Payment
If you are looking to lower your LTV ratio for commercial property, you can always make a larger down payment. While this may require some strategy, the larger the down payment, the lower your LTV ratio will be. This can lead to substantial savings with borrowing costs.
Budget for Property
While many investors are looking for specific commercial real estate properties, staying in line with your budget is a good way to create a successful path for long-term growth. By opting for a property that’s within your price range, you’ll be able to increase your down payment, lower your LTV, and avoid unnecessary costs.
Real Estate Market Shifts
The real estate market is dynamic—it changes alongside consumer demand. If the market goes down, your property value may decrease and therefore, raise your LTV ratio. If the market goes up, your property value may increase and therefore, lower your LTV ratio. Looking at past mortgages and the fluctuations in value on the property you’re interested in acquiring can help you better understand future market shifts. To make sure that you avoid problems with your investments, beginning with a lower LTV ratio is preferable.
Limitations When Using a Loan-to-Value Ratio
When using LTV ratios, the implications are subjective. It’s not an exact science and just because you have a high LTV ratio doesn’t mean you won’t be approved for commercial financing. While it’s a good measure of risk for lenders, it’s not the only thing that should be considered.
To make sure you’re obtaining the best financing available, PACT Capital is here.
PACT Capital is a California based mortgage banking firm with long standing relationships with lenders of all specializations and parameters. We partner with our borrowers to get an understanding of their experience, goals, and financing needs to connect them with lenders who align with their interests. Our collective business and real estate credit experience allows us to utilize opportunities in the commercial real estate market where other lenders cannot compete. When you work with PACT, you have access to the entire credit market at your fingertips.
To learn more about our commercial financing options, email info@PACTCap.com, or call 213-799-PACT (7228) today.