Loan-to-cost (LTC) is a common metric in commercial real estate. Lenders use the loan-to-cost ratio to evaluate how much debt they will lend on a value-add or construction real estate project relative to its total cost. It’s one of the main metrics CRE lenders use to determine how much risk they will take on for a given CRE project.
Read on to find out how to calculate LTC, examples of how this metric is used in commercial real estate investments and the difference between LTC and loan-to-value (LTV).
The value of commercial real estate property is typically determined by how much income it can produce. Yet for a construction deal, renovation project, or a property that doesn’t yet have stabilized value, lenders and borrowers use LTC to evaluate the potential value of a deal.
“LTC is a way of gauging how much leverage a lender will lend a borrower before the value of a property is stabilized,” Gunnar Wilmot, Senior Financing Expert at Lev, told lev.co. This CRE metric indicates a lender’s total investment in a construction or renovation project relative to the total cost of the CRE project expressed in a percentage.
To explain the concept of LTC, Wilmot shared an example.
Say you want to buy a piece of land for a million dollars to build an apartment complex on that land. The land and construction would cost you $3 million. The entire renovation, with furniture and plumbing etc., costs another $2 million. That adds up to a $5 million deal, but there’s no value to the property yet.
LTC means a lender is basing a loan amount on the total cost of the project, which in this case is $5 million, and its potential value, rather than the current stabilized value, which is $0. When calculating LTC, the total cost includes hard costs and soft acquisition costs. Essentially, you’re going to include anything that is related to the cost of the project.
Loan-to-cost is expressed in a percentage. The formula to calculate loan-to-cost is:
LTC = loan amount / total construction cost (x100)
Here’s how the formula would look for the example above if this borrower received a $3 million loan:
70% LTC = $3.5 million / $5 million (total cost of construction) (x100)
Determining the loan-to-cost ratio is a matter of understanding how much the total project will cost and how much debt you are seeking to borrow for the project. LTC typically ranges from 65% to 75% and up to 85% or 90% in some cases. The higher the LTC, the more risk the lender is taking.
There are many factors that will determine the LTC, including the profile of the deal, the asset class, the exit strategy, the real estate market, and whether the loan is recourse or nonrecourse, Matt Rubin, Associate at Lev, told lev.co.
It’s important to understand the difference between loan-to-cost and loan-to-value, two common metrics used in CRE lending. While LTC refers to the estimated value of a property before it’s stabilized, loan-to-value is the term used once the property is completed and its cash flow has reached its full potential.
The metric lenders use will depend on whether you’re adding value to the property or the property is already fully stabilized.
“If you have a stabilized property, you’re going to base the loan on the loan-to-value, since nothing is changing,” Wilmot said. “So when you’re talking about LTC, it usually just means you’re asking for more money than the property is currently worth today, because you’re about to do some improvements.”
The formula to determine the loan-to-value ratio is straightforward. You simply divide the loan amount by the value of the property. In the previous example, because the loan is $3.5 million, and the property is now worth $5.5 million, the LTV would be 63%. As the property increases in value, the ratio of the loan to value decreases.
When investors and lenders are thinking long-term about a property, ideally the future stabilized value of the LTV should be much lower than the LTC, Wilmot said. “If I’m lending you $1.5 million at an 80% loan-to-cost, I’m needing that property to be worth more than $2 million upon completion of the work. Then my loan will be below 75% loan to value. That’s how LTC lenders are thinking.”
The loan-to-cost ratio is used when you are adding value to a property. This value includes new constructions, rehabilitation projects, flips, renovations, ground-up constructions and bridge loans. Basically, lenders will use LTC for any situation where a property has not yet reached its full income potential.
To secure a loan that is based on a value-add CRE project, a lender will have to be convinced the investment will be worth it and the property will increase in value once the project or renovation is complete.
“Lenders want to get involved with what improvements are being done to the property because they have to make sure that the value is there at the end of the day,” Wilmot said.
Typically, borrowers will have to show data that they’ve done a project like this before, and they have the expertise to execute the project. For example, they’re going to have to show who they’ve hired to build the property, and that company has to be a reputable and approved general contractor from the lender.
Once the lender has determined the project is feasible and has approved the project, they will typically grant the loan in installments. “The lender typically will allow the borrower to draw down on their construction loan monthly or as they need it because they want to monitor what’s being spent. Lenders are not going to risk just giving someone $2 million without a very clear stabilization and exit strategy. They’re going to be very cautious about how that money is spent,” Wilmot added.
If you’re new to commercial real estate, you’ll likely come across the term, loan-to-cost or LTC, often. It’s one of the first metrics you’ll notice CRE lenders list, and it’s an essential ratio for CRE value-add projects that will tell you how much risk a lender is willing to take on a project. The higher the risk, the more money a lender will be willing to invest in a project upfront, and the higher the LTC. Once the property is stabilized, ideally, the value of the property will be higher than the total cost invested, and the LTV will be considerably lower than the LTC.
