Loan To Value and Loan To Cost Ratios In Apartment Finance
The process of determining the amount a lender is willing to provide for an apartment building purchase (or other piece of commercial real estate), is made up of many factors that come into play such as property type, property class, location, sponsorship, DSCR (debt service coverage ratio), and more. Of all of the factors, however, one of the primary components used by multifamily loan underwriters to determine a loan amount is leverage. The leverage of any apartment loan transaction is summed up, and determined based on the LTC or “loan to cost ratio, and the LTV or “Loan to Value” ratio.
Apartment Loan LTC: Loan To Cost Ratio
LTC stands for loan-to-cost ratio. The LTC is a ratio used in multifamily mortgage finance as well as commercial real estate financing to determine the ratio of debt in relation to the total cost of the project in question. LTC is used most frequently for value-add acquisitions such as ground-up construction or the acquisition of properties that require substantial rehabilitation. The "C" in LTC refers to the total project cost. More accurately, in the case of an acquisition, it is the total cost required to purchase the property, then bring it to stabilization. So, in a scenario where an investor is building a 100 unit apartment complex, and they are looking to determine their cost, the total cost would be the sum of the cost to acquire the land + the cost to build the community + the cost to bring it to stabilization.
The formula for LTC (the loan to cost ratio) is:
LTC = Loan Amount / Total Cost
So if the cost to buy the land is $3MM, the cost to build the property is $6.5MM, and the cost to get it fully leased up and stabilized is $500k, the grand total cost would be $10MM. If an investor were looking for a 75% construction loan, the loan would be $7.5MM (75% of the total cost). It is important to keep in mind that the value of the property has nothing to do with the LTC; the value of the property is only a factor for determining LTV.
Commercial mortgage lenders utilize LTC as a factor to determine the potential risk in a deal. The rule of thumb is the lower the leverage, the lower the risk. Conversely, higher leverage offers higher risk. If an investor is buying a distressed property for $1MM, but its actual value is $2MM, and they are looking for a loan to finance the acquisition of said property, lenders will traditionally look at the LTC (the cost, being 1MM) and not the LTV, or to be more specific, the lender will be looking at the lesser of the two.
LTV: Loan To Value Ratio
LTV stands for loan-to-value ratio. The LTV ratio is used in apartment mortgage finance and commercial property financing to determine the ratio of a particular debt (like a first mortgage) in relation to the value of the collateral (in this case an apartment property or other commercial property). For example, If a borrower owns a property worth $10 million, and is looking to refinance a first mortgage for $7 million, the LTV of the transaction is 70%. Lenders use this figure to determine their level of risk and borrower leverage in a transaction.
The formula is for LTV (the loan to value ratio) is:
LTV = Loan Amount / Total Value
Like with leverage, the lower the LTV, the lower the risk. This formula is mainly used in the case of standard purchases and refinances. In the cases of multifamily property rehabilitation, or ground-up construction, other metrics like LTC become more useful factors. When LTV is used in the case of a rehab, new construction, or other value-add financing opportunity, it is used as a leverage constraint for the finished, or stabilized value of the property.
So for instance, the cost to build a property is $10MM, and when it's complete and stabilized it's worth $20MM, and the lender has constrained you to the lesser of 75% LTC or 70% LTV. In this scenario, the loan would be the lesser of $7.5MM (75% LTC) and $14MM (70% LTV). Of course, in the real world in this case there is no shot at a $14MM loan because that would be 140% of total cost! There simply aren't many lenders out there that are willing to cut you a check for 100% of the project cost, let alone add another $4MM on top of that just because of some metrics. Leverage constraints exist to keep borrowers committed to their deals and keep banks from having to get into the construction and real estate management business.
Apartment Loan Risk Mitigation
As we’ve mentioned earlier, after a loan is fully underwritten, the lender will traditionally offer financing that is constrained by the lesser of a predetermined LTC, LTV, and in many cases, DSCR as well (some lenders in particular cases also frequently add debt yield as a requirement as well). The most common terms you will find for multifamily construction financing are structured like this:
$XXX MM (or maximum proceeds), subject to (a) maximum loan to cost ratio of 75%, (b) a maximum loan to value ratio of 70%, and (c) a minimum debt service coverage ratio of 1.25x based on lender's underwriting.
With this in mind, investors should avoid getting too excited if their loan amount based on lender LTC or LTV calculations looks above and beyond what was expected, because the standard is that borrowers will only receive the lesser of the two amounts, or quite often the lesser of three or four different ratios. Investors should understand that lenders are experts in risk mitigation, and that means they know how to manage leverage and loan amounts.