Commercial real estate (CRE) professionals often encounter the term ‘loan to value’ (LTV) ratio in their line of work. But what is loan to value, and how does it affect CRE decision making? LTV can affect things like loan amounts, loan terms, and interest rates for borrowers. It can sometimes make or break a commercial real estate deal.
In this guide we delve into all things LTV, so that you can be prepared when that next great CRE deal comes around.
Understanding the Loan to Value Ratio
The loan to value ratio is a risk assessment tool used by lenders. It expresses the percentage of a property's value that the lender is willing to finance.
Calculating the LTV ratio is very easy. Simply divide the loan total by the property’s market value and multiply the result by 100.
Practical Example of LTV Calculation in CRE
To illustrate how the loan to value ratio is calculated in a commercial real estate scenario, let's consider a property with an appraised value of $2,000,000.
A borrower is looking for a loan of $1,500,000 to buy the property.
What is loan to value in this example?
LTV ratio = ($1,500,000 / $2,000,000) * 100 = 75%
This means that the loan amount represents 75% of the property's full value.
What Do Different LTV Ratios Mean?
Different LTV ratios can imply different levels of risk in CRE. A lower LTV ratio, such as 60%, indicates a smaller risk for the lender because the borrower has more equity in the property.
On the other hand, a higher LTV ratio, such as 90%, means that the borrower has less equity invested in the property. Lenders consider higher LTVs riskier because there is more to lose should the borrower default on the loan repayments.
What is Loan to Value in Commercial Real Estate?
Why should CRE professionals be interested in LTV? As we’ve seen above, loan to value plays a critical role in both borrowing and lending decisions in the CRE sector.
Borrowers need to understand the impact of LTV on their borrowing capacity and the terms of the loan.
For borrowers, a lower LTV ratio provides a better chance of securing a loan, and better yet, one with more favorable financing terms.
The challenge for borrowers with a low LTV is they may struggle to source the remaining finances, which might be the difference between going ahead with a deal or not.
Lenders might allow cash-strapped borrowers to increase their LTV but due to the higher potential risk, the interest rates will be higher leading to larger monthly repayments.
In this instance, the borrower – who might be a CRE investor – needs to carefully balance the amount of equity they place in a property in relation to the cashflow that property produces.
A fully let office block for example, might bring in a healthy cashflow from rentals, but if the landlord bought it at a high LTV with elevated interest rates, their monthly interest repayment could nullify any potential profit.
It’s best for CRE professionals to always plan for a lower LTV when crunching the numbers. That way, the success of their commercial property isn’t determined by the bank’s goodwill.
Usually, if a borrower is considered a high risk, or the LTV is high, the borrower is required to take out mortgage insurance to protect the lender's interests.
Alternatively, they may need to provide additional collateral or personal guarantees.
The Impact of LTV on Borrowers in CRE
The LTV ratio has a direct impact on the terms and cost of a CRE loan for borrowers. A lower LTV ratio can result in significant cost savings over the life of the loan. This is because a lower LTV ratio often leads to more favorable interest rates, which means better monthly cashflow.
Conversely, a higher LTV ratio may result in higher interest rates, increasing borrowing costs. It may also increase the need for additional guarantees or insurance to mitigate the lender's risk.
It’s easy to see why it is important for borrowers to carefully assess the LTV ratio and its implications before entering into a loan agreement.
Variations on LTV Ratio Rules: Different Loan Types in CRE
In CRE, loans are not a one-size-fits-all. There are several different loan types such as:
- Bridge loans
- Mezzanine financing
- Hard money loans
- Small business administration loans
- Construction loans
Different loan types have varying LTV ratio requirements.
Conventional lenders, like banks, often maintain industry-standard LTV ratios, typically in the range of 60% to 80%.
However, less traditional forms of financing, such as hard money loans or bridge loans, may accommodate higher LTV ratios.
The increased risk associated with these high LTV loans is typically offset by higher interest rates.
LTV vs. Combined LTV (CLTV) in CRE
In addition to loan to value, there is another relevant metric in commercial real estate, known as ‘combined loan to value’ (CLTV). LTV focuses on the relationship between the loan total and the property value. CLTV takes into account multiple loans secured by the same property.
CLTV can be calculated by adding the total loan amounts secured by a property and dividing it by the property value.
This metric is particularly important when refinancing or when there are subordinate loans.
As with LTV, a higher CLTV ratio implies a higher level of risk for lenders as it indicates a greater exposure to potential losses. Lenders may impose stricter requirements or higher interest rates on loans that have higher CLTV ratios.
What is a Good LTV Ratio in CRE?
While industry standards may vary, a ‘good’ LTV ratio in commercial real estate typically falls within the range of 60% to 80%. This indicates that the borrower has a substantial equity stake in the property, making the loan less risky.
However, the ideal LTV ratio depends on various factors, including:
- Property type
- Market conditions
- Borrower's creditworthiness
- The lender's risk appetite
Disadvantages of Using LTV in CRE
It's important to acknowledge the limitations of relying solely on the LTV ratio in CRE. While the LTV ratio provides valuable information about the loan's risk level, it doesn’t take other essential financial metrics into account.
Metrics such as net operating income (NOI) or capitalization rate (cap rate) provide a more comprehensive view of a property's income potential and return on investment.
A balanced approach ensures a more accurate assessment of the property's financial health. In turn, this helps to avoid potential pitfalls.
Final Thoughts on the Role of LTV in CRE Decision-Making
It is vital for CRE professionals involved in borrowing, lending, or investing in commercial real estate to understand loan to value. The LTV ratio serves as an important indicator of borrower risk and plays a significant role in determining the terms and cost of a loan.
Remember to also consider other financial metrics, such as NOI, cap rate, and CLTV. By adopting a balanced approach to assessing financial health, you can navigate the CRE industry more effectively, optimize your investment strategies, and make the best investment decisions possible.
