Both the LTC (loan-to-cost) and LTV (loan-to-value) ratio are key factors in any commercial real estate construction project. Find both outlined below, but if you'd like direct advice, don't hesitate to reach out to us at SBA7a.loans.
What’s a Loan to Cost Ratio?
The loan to cost ratio is a commercial real estate construction term. It describes the relationship between the construction loan (“loan”) and the actual cost of construction (“cost”). It’s the loan amount divided by the construction cost, which yields a percentage -- the loan to cost ratio.
To get a clearer picture, let’s look at loan to cost ratio in action. Imagine a construction project that costs $500,000. The developer needs a loan to get this project started, so the lender offers a $400,000 loan with the expectation that the developer will shell out for the remaining $100,000.
So, the LTC ratio would look like this:
$400,000/500,000 = 80%
The LTC ratio for this project would be 80%. If you play around with it, you’ll see that a high loan to cost ratio would mean the lender is taking on more risk; whereas a lower loan to cost ratio means that the borrower would have more equity invested in the project.
What is the Loan to Value (LTV) Ratio?
Loan to value ratio, like loan to cost, is another term used in commercial real estate construction. It compares the amount of the loan (“loan”) to the estimated value of the building post-construction (“value”). Like the LTC ratio, for the LTV ratio we use the actual loan amount for the “loan” portion of the ratio, but value is subjective -- which is why it’s determined by a property appraiser.
So, what does a commercial appraiser look for when they’re determining the future value of a construction project? They’ll look at the value of similar properties in that particular area. They’ll also consider the income that’ll be generated from the commercial building -- if it’s an apartment building, this would be the amount of rent paid by tenants. Using our same example above, let’s look at LTV in action:
Loan amount: $400,000
Estimated future value of the property: $800,000
The LTV ratio, then, would be 50%. As a rule of thumb, the higher the LTV ratio, the more of a risk the project is for the lender. The lower the LTV ratio, the lower the risk to the lender.
How Do LTV and LTC Apply to SBA Loans?
If you’re hoping to use an SBA 7(a) loan or other commercial real estate mortgage to finance new construction, your lender will use the LTV and LTC ratios to determine how much they’re willing to loan you for your project. If the commercial real estate appraiser estimates a much lower future value than you expected, it’s not a bad idea to ask your bank to get a second opinion from another appraiser. After all, these ratios will be the sole determinants of how much “leverage” you can get in terms of funding for your project -- so it’s important that they’re as close to correct as possible!