What Is LTC, And What It Can Tell You?
Loan-to-cost ratio (LTC) is a formula used to compare the amount it costs to finance a commercial real estate project with the amount it costs to build it. The formula is used by lenders to determine the risk of underwriting construction loans. If the LTC is higher, it indicates that the project is riskier. Most lenders cap the LTC at 80%, shying away from anything greater. Those which do lend, impose a higher interest rate.
Simply put, the LTC formula is the total amount of the loan, divided by the hard construction costs. For example, your commercial real estate project will cost $200,000 to construct. The lender will provide you with a loan in the amount of $160,000. The LTC ratio would be 80%.
What Does LTC Mean To Your Business?
Construction loans are deemed to be riskier than residential mortgages. There is a chance you may not complete the project on schedule or according to specs. Fluctuations or disruptions in the economy could impact your overall construction costs, and your ability to lease or sell the project.
Banks have become much more conservative. They want to see that you have cash equity, typically around 20%, that will remain in the project until you secure permanent financing or repay the loan. This has resulted in lower loan amounts based on LTC ratios.
The LTC formula includes acquisition costs, if applicable, construction costs, and all associated fees, such as legal expenses and appraisals. If the land costs you $750,000 and construction will cost you $1 million, and you apply for a loan in the amount of $1.5 million, the LTC is going to 85%.
LTC is about hard numbers. Lenders look at the numbers and determine if it makes sense to pay for the construction or not.
Knowing the average LTC that is accepted by lenders for your type of project helps to establish a budget that will get your project off the ground. LTC requires you to establish actual total project costs. Lenders make their decision based on what you realistically anticipate you will spend to complete the project.
If you can demonstrate a lower LTC, you will qualify for favorable loan terms, meaning that the cost of financing is going to take less from your overall profits once the project is completed.
LTC Vs LTV
LTC is different from LTV, another formula used to determine the risk of your project.
Loan-to-Value ratio (LTV), compares the total loan amount against what the value of your project will be once it is completed. It is more difficult to calculate the expected value of a project that has not yet been constructed, therefore an appraiser is usually involved. To determine future value, the appraiser compares your project to similar properties. The anticipated income that will be generated is also considered.
Let us assume you are building your commercial project in one of the most expensive cities in the country, where there is high demand. The expected market value upon completion lowers the risk for lenders. For example, you receive a loan of $150,000 and the expected market value of your finished project is $200,000. The LTV is 75%.
Loan-To-Cost Ratio In Action
LTC plays an important role when determining the risk associated with construction loans. However, there are other mitigating factors that may come into play. For instance, the value of the land where the building is being constructed, the location, and your own experience and reputation in the construction industry.
Consider these two examples of how LTC might come into play when evaluating your loan application.
A developer seeks a $7 million construction loan to transform a vacant bank branch building into medical suites. The LTC is a little on the high side at 77%. However, the abandoned facility is situated in the southern California submarket, an excellent location with high potential for leasing once the project is completed.. When weighing the extenuating circumstances, the bank does not view the project as risky.
Consider a second rehab project. You intend to purchase a distressed property and do a complete renovation. The market value of the building is $150,000. You purchase it for $100,000. The lender finances your project for $90,000. The LTV is only 60%, a much lower risk for a lender, netting you more favorable financing terms.
Loan-to-cost ratio (LTC) is one of the most common formulas used by lenders when considering an application for a construction loan. The higher the LTC, the higher their risk. The extent to which you can present financing that results in a modest LTC, the greater your likelihood of successfully securing a loan with favorable terms.