Understanding Loan to Cost Ratio in Commercial Real Estate

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Commercial real estate is a highly profitable market, but it comes with significant risk. Thus, there are different metrics to measure the risks associated with their real estate investments.

Of all the available choices, the loan-to-cost ratio is the most preferred one for real estate construction projects like value adds redevelopment or ground-up development projects.

The metrics help measure the debt acquired to finance a project compared to the project’s total cost. In simple words, the higher LTC ratio indicates the developer has taken considerable leverage to complete the project, which in turn increases the associated risk.

LTC ratio- What is it, and how to use it?

The loan-to-cost ratio is a standard calculation metric. Real estate investors use it to measure the leverage available on a commercial real estate project. It helps compare the total amount of debt used in the project to calculate the cost used to complete the construction project.

The higher the LTC rate or ratio will be, the more debt the developer has used for the construction, making the entire project risk. It is an essential metric for investors, especially for ground-up construction components.

For instance, most real estate crowdfunding platforms allow investors to invest in commercial real estate bridge loan, which is offered to the developers as an equity investment for developmental or redevelopment projects.

A great way to assess the risk profile of the opportunity is by calculating the LTC ratio of the project. Remember, when the percentage is closer to 80%, there is a higher risk as it shows the financing includes less equity from the developer’s side.

Importance of loan to cost ratio

The loan-to-cost ratio is an essential metric that the hard money lenders in Illinois use for real estate construction loan underwriting. It is done by limiting the loan amount, which is directly related to the cost of the property.

For a borrower, understanding the LTC for their property type will help establish a secure budget for the project. It includes the total amount of equity the borrower needs to contribute to the project. Can provide the share in different forms. It can be either all in cash or a mix of land and money.

Besides this, the interest rate on loans is greatly affected by the LTC. For instance, consider a hard money lender offering a 60% LTC ratio for rehab loans. You can undoubtedly find a lender who can provide you with higher LTC, but it will come with more interest rate. It is simply because of the associated risk. The higher the LTC will be, the more chance the lenders assume. 

It means the entire point of the LTC in the real estate sector is the property here serves as collateral for the amount provided for completing the project.

Herein, the lender must recoup the loss in case of a default. Therefore, when there is a higher LTC, the borrower needs collateral to secure the funding. Thus, there is a higher interest rate to offset the risk.

How to calculate LTC?

The LTC ratio is used to calculate the loan percentage of the funding amount a lender can provide compared to the project’s total construction cost. The investors calculate the ratio by dividing the total loan amount by the total project cost, including the construction cost.

For example, let’s consider a developer who has estimated an unlimited amount of $1 million for completing a multi-family project.

It includes closing costs, land acquisition construction costs, and other fees. A hard money lender might agree to offer him a $750,000 construction loan to finish the project. It means the developer must invest $250,000 of equity from his side. Thus, the LTC ratio for such a project will be 75%.

LTC and LTV- What’s the difference?

Besides LTC, the other essential metric used for calculating the risk is a loan to-value ratio or LTV. Commercial real estate investors use this metric to measure the debt amount compared to the market value.

Similar to LTC, LTV is used to assess the risk associated with the project. Herein, the higher percentage shows greater risk.

Commercial real estate investors make use of LTV to measure the leverage on the property. For instance, if a lender offers $800,000 of senior debt financing to complete an office building with a market value of $1 million, it will consider the LTV to be 80%.

Further, the investors also use LTV to measure the leverage when the redevelopment or development project increases the property value above the initial cost.

For instance, a crowdfunding platform can offer the opportunity to investors to invest in value-added multi-family properties. Consider the initial purchase price of $100,000. Herein the sponsor expects to use two $250,000 for renovation or improvements in the unit. The lender is willing to offer an $800,000 loan on the property.

When the project is completed with all the renovations, the borrower expects to increase the rents making the property’s net operating income higher. According to the estimates of the sponsor, the property will potentially sell at about $1.35 million.

Commercial real estate investors must do due diligence before offering capital for a deal, especially when there is a higher-risk project. It is the LTC ratio that affords them the proper assistance to keep their wealth safe.

Pros of LTC ratio

The LTC ratio is an essential metric for financing real estate projects.

Accuracy: LTC ratio requires the total project cost but not just the appraisal. Thus, the results are accurate.

Reality: The lenders offer the capital based on the amount a borrower is willing to spend on the project. Herein they will review the contractor’s construction budget and other essential information.

After comparing and contrasting the detailed construction budget with the lenders and their proposed construction, they will find the reality of the amount used for the project. Thus, it helps guarantee to safeguard the capital investment.

When to use LTC or LTV?

The LTC ratio measures the debt of the overall project cost, while the LTV helps assess the debt against the property’s market value. In both cases, when other factors are equal, a higher value shows a more significant risk as the borrower offers less equity in the investment.

However, it is LTC that is an appropriate way of accessing the risks.

Conclusion

Real estate investments have become an effective way of getting financial independence as it offers better returns and has significant tax breaks.

But to gain maximum benefit, you should have professional support. Private Capital Investors has a team of skilled professionals who can offer the proper assistance to ensure you invest the right amount in your property.

From helping understand the associated risk to acquiring the loan amount, we can provide you with all the assistance you need to excel and get better returns.

So, instead of taking the risk, better contact us to get the help you need with your real estate investments. We assure to offer you timely and quick services.

Want to learn more? Get in touch with us today.

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