Real estate investors use a variety of metrics to measure the riskiness of commercial real estate investments. The loan-to-cost ratio, or LTC, is a common one used primarily for real estate construction projects like ground-up development or value-add redevelopment. The loan-to-cost ratio measures the debt used to finance a project compared to the total cost of construction. Thus, the higher the LTC ratio, the more leverage a developer has taken on to complete a project, which increases its risk profile.
What is an LTC ratio, and how is it used in CRE?
The loan-to-cost ratio measures the leverage of a commercial real estate (CRE) project. It compares the amount of debt used as a percentage of the total costs to complete a construction project, whether that be a ground-up development or a value-add redevelopment. The higher the rate, the more debt a developer is using to finance construction, making the project riskier.
The LTC ratio is an important metric for investors in commercial real estate projects with a value-add or ground-up construction component. For example, many real estate crowdfunding platforms offer the opportunity to invest in real estate loans provided to developers as well as equity investments in development and redevelopment projects. One way investors can gauge the risk profile of these opportunities is to calculate the LTC of the project. The closer that percentage is to 80%, the riskier it is since there's less equity cushion provided by the developer.
How do you calculate LTC?
The LTC ratio calculates the percentage of a loan or the amount of funding a lender is willing to provide compared to the total construction cost of a real estate project. Investors calculate it by dividing the loan amount by the total cost of the project, including the construction cost.
For example, a developer estimates that it will cost $1 million to complete a multifamily project, which includes land acquisition, closing costs, permitting and other fees, and the construction cost. A hard money lender has agreed to provide a $750,000 construction loan for this project, implying that the developer needs to invest $250,000 of equity. Thus, the LTC for this project would be 75%.
What's the difference between LTC and LTV?
Another important metric used by commercial real estate investors is loan-to-value, or LTV. This metric measures the amount of debt compared to the appraised or fair market value of a property. Like LTC, LTV helps commercial real estate investors gauge the riskiness of a project, with a higher percentage indicating greater risk.
Commercial real estate investors primarily use LTV for measuring leverage on a stabilized property. For example, if lenders will provide $800,000 of senior debt financing on a fully leased office building that's on the market for $1 million, the property has an LTV of 80%.
However, investors can also use LTV to measure leverage where the development or redevelopment investment will increase the property's value above the initial cost. For example, a crowdfunding real estate platform offers the opportunity to invest in a value-add multifamily property. The initial purchase price is $1 million, and the sponsor expects to spend $250,000 on improvements to renovate the units. A lender is willing to provide an $800,000 mortgage loan on the property.
Upon completion of the renovation projects, the borrower anticipates the renovation will allow for increased rents, which would boost the property's net operating income (NOI). In the sponsor's estimation, it could potentially sell the property for $1.35 million. Here's a look at the LTC and LTV ratios on this example:
|LTC ratio||$800,000 / ($1,000,000 + $250,000)||64%|
|Post-renovation LTV ratio||$800,000 / $1,350,000||59%|
With both percentages well below the 80% danger level, this would be a less risky investment.
Another way to measure risk
Commercial real estate investors need to do their due diligence before putting capital into a deal, especially a riskier one like a development project. One of the ways to gauge the risk profile of an opportunity is to look at the percentage of debt used to finance the project via the LTC ratio. The further below 80%, the more cushion an investor has should something go wrong.
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