Loan to Cost and Loan to Value
Loan to Cost Defined – LTC is a metric in commercial real estate that measures the ratio between the total loan amount and total cost of the project. Cost is either used as construction costs or purchase price, depending on the deal. For example, the loan to cost for a $10,000 construction project with $7,000 in financing is 70% ($7,000 divided by $10,000). Similarly, a burrower purchasing a new home for $3,000,000 with only 10% ($30,000) down will have a LTC of 90%.
Loan to Value – LTV is a metric in commercial real estate that measures the ratio between the total loan amount and fair market value of the project. For example, a loan to value of a building worth $200,000 and a loan of $150,000 has an LTV of 75% (150,000 divided by 200,000).
Lenders use both to measure risk – the higher the percentage the higher the risk to the lender. If a property is purchased at 60% LTV, it is safer than 80%, because the burrower has injected more cash into the deal – indicating better financial strength.
What is the Difference Between LTV and LTC?
When considering risk loan factors, lenders will use LTV and LTC to underwrite a deal. So what is the difference between them and why you should use one or the other?
The key difference comes into play when you purchase a property for a steep discount. For example, consider the following case study of a request for a hard money loan on a mobile home park:
Property A is purchased for $100,000, but it has a fair market value of $150,000. A loan for $90,000 for the purchase represents a 90% loan to cost, which most lenders will avoid – it represents high risk since the burrower does not contribute enough capital of his own. But when using loan to value, the figure is 60% – much close to what lenders consider a safer investment.
Framing the deal around loan to value falls under the risk parameters most lenders are looking for – which could represent a lower risk profile than a high loan to cost.
Should you use LTC or LTV?
Loan to cost and loan to value indicate a level of risk to the lender – a higher percentage indicates a greater risk because the burrower has less equity interest in the project.
When comparing loan to cost and loan to value, you need to ask yourself what is better suited to measure your investment. If you are trying to evaluate a construction project – LTC is a better measure because you need to consider construction costs and the finance requirement to see if the project is viable. When purchasing a turn-key asset, LTV is a better measure because in all likelihood – the fair market value is close to the purchase price.
Loan to cost is effective at deals when an investor has to infuse additional cash at closing in order to complete the transaction – and LTC can better measure the true cost of the deal. For example – a purchase of an office building with a hard money loan will require an additional $15,000 to satisfy a mechanic’s lien. In order to capture the actual cost to purchase – we’ll need to add the lien and closing costs to the purchase price.
The big difference between LTV and LTC comes into play in fix and flip loans – when the final fair market value of the property is higher than the purchase cost (hopefully this is the case). Real estate professionals who come to us for a fix and flip hard money loan need not just funds to close the deal, they also need to make sure they have enough capital to renovate and market the property for sale. We us a very similar risk analysis when we provide clients with a car accident loan.
On numbers alone, loan to cost ratio will be well above 65% in almost any fix and flip hard money loan, indicating high risk that most lenders would want to avoid. But when analyzing the project from a loan to value perspective, the numbers change and makes more sense – since the final value of the project is expected to be higher than the purchase price.