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When you are analyzing a possible investment the project’s LTV is a key factor to understand the risk.
What is the loan to value ratio, and how can it impact the risk in the investment?
We’re going to look at what the loan to value ratio is, what a good one is, and why it’s an essential factor in whether a lender will approve your loan or not.
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What is Loan to Value?
The Loan to Value (LTV) ratio is a frequently used formula that financial institutions and other lenders review before they approve a mortgage. The LTV ratio reflects the loan amount you are applying for versus the property’s assessed value.
Lenders frequently look at LTVs as a benchmark for how likely the borrower will make payments. As a rule, the higher the LTV ratio, the higher the risk associated with the mortgage loan. Consequently, if the loan is approved, higher LTV loans will often be priced with a higher interest rate.
A high LTV might also require the borrower to purchase mortgage insurance to help offset the additional risk to the lender.
Lenders like lower LTVs, because they require applicants to come up with more money for their down payments.
Loan to Value vs. Loan to Cost (LTC)
Loan to Value and Loan to Cost are formulas that mortgage lenders rely on to help establish the level of risk associated with a loan.
Loan to value is used to compare the loan amount to the purchase price.
Loan to cost is used to compare the amount financed on a project compared to the construction costs to complete the project.
In other words, LTC looks at the total costs of a project, and LTV looks at the acquisition price.
Why Is a Good Loan to Value Ratio So Important?
A good LTV ratio is important because it is a critical factor that lenders look at for securing a mortgage. The lower the LTV, the lower the risk for the investor.
A lower LTV ratio can help borrowers receive better mortgage interest rates. As the LTV ratio rises, so do the interest rates offered by the lender.
When an LTV ratio climbs over 80%, the lender might require that the borrower acquire private mortgage insurance (PMI). PMI can add 0.5% to 1% of the total mortgage amount annually.
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How to Calculate Loan to Value Ratios?
The Loan to Value ratio is calculated by dividing the mortgage amount by the property’s appraised value and expressing it in a percentage.
LTV Formula:
Mortgage/Appraised Value of the Property = Loan To Value Ratio
Let’s say you’re looking at a property assessed at $100,000 and want to make a $15,000 down payment, resulting in a mortgage of $85,000.
The result is the LTV ratio:
$85,000 Mortgage / $100,000 Assessed Value of the Property = 85% LTV
As you can see in the formula, the higher the down payment made, the lower the LTV ratio. Lenders look at the LTV ratio because they view it as a solid indicator of whether or not a borrower will default on the loan.
What Is a Good Loan to Value Ratio?
As a rule of thumb, lenders consider any Loan to Value ratio of less than 80% as a good LTV. One reason is that many lenders expect borrowers to put 20% of the value of a property as a down payment.
With a loan to value ratio of less than 80%, a borrower will be eligible for more favorable mortgage terms and lower interest rates on the mortgage.
However, a good LTV depends highly on the mortgage a borrower gets. For example, a conventional mortgage loan expects an LTV ratio of 80%, while one is looking for an FHA loan; the LTV ratio could be as high as 90% with a credit score in the mid-500s.
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Loan to Value Ratios and Secondary Real Estate Markets
LTV ratios give investors in commercial real estate a benchmark for the amount of risk involved in investing in a property, including secondary market properties.
Accredited investors, sponsors, and real estate investors are looking more and more toward the secondary market in commercial real estate for investment opportunities.
Secondary market commercial properties are ones where the initial funding round has been completed and the holding period has passed, or the sponsor gives their blessing to initial investors in the property selling all or part of the shares in the property.
Platforms like SecondRE’s Marketplace connect accredited investors with real estate investors looking for liquidity by selling all or fractions of their holdings in cash-generating real estate properties with the sponsor’s consent.
Accredited investors get access to investment properties that might still be in a holding period. Current real estate investors can gain liquidity from selling their shares. Sponsors get access to a new pool of accredited investors while providing current investors an easier exit from their commitment.
The Loan to Value Ratio is a Key Factor in Assessing the Risk in Investing in a Commercial Property
LTV ratios give investors in commercial real estate a benchmark for the amount of risk involved in investing in a property, including secondary market properties.
The loan to value (LTV) ratio is the percentage of a property’s mortgage divided by the assessed value of the property.
For most types of investments, an LTV ratio of 70% or lower is considered good. However, LTV ratios of 80% are acceptable for commercial real estate loans depending on the type of loan they are pursuing.
The secondary commercial real estate market is seeing a boom. Real estate investors with current holdings looking for liquidity can find them by working with companies like SecondRE, which can connect them with accredited investors who can purchase all, or a fraction of their shares with the sponsor’s blessing.
Related: What is “Liquidity” in Real Estate and When is it Needed?
