Loan-to-Cost Definition for Real Estate Investors

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Key Takeaways

  • Loan-to-cost is a ratio used by lenders to “size” a commercial real estate loan.
  • Loan-to-cost is calculated as the loan amount divided by the purchase price or construction cost, depending on whether a borrower is purchasing an existing building or starting a construction project.
  • From a lender’s standpoint, the decision about what loan-to-cost to offer depends on a variety of factors including property type, borrower strength, risk appetite, and credit policy.
  • When inquiring about a potential CRE loan, borrowers should inquire with several different lenders about their maximum LTC and use this information to drive their financing strategy.

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A Commercial Real Estate Investor’s Guide to Loan-to-Cost

Nearly every commercial real estate purchase includes some amount of debt. And, one of the questions that many investors have regarding debt is, “what is the maximum loan amount that I can get for a property?” There are several different ways that lenders can arrive at this amount, but one of the most common is a metric known as “loan-to-cost.

In this article, we are going to discuss loan-to-cost. We will describe what it is, how it is calculated and how it is commonly used to “size” a loan amount. By the end, readers will have the information needed to calculate this ratio as part of their own pre-investment due diligence process.

At First National Realty Partners, we specialize in the acquisition and management of grocery store-anchored retail centers and always calculate loan-to-cost as part of our due diligence process. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.

What is Loan To Cost?

The loan-to-cost ratio is a metric used by banks and other lenders to “size” a loan request. Or, another way to think about it is as a ratio that allows a lender to limit their risk in a given loan.

Loan-to-cost is not an arbitrary number. It can vary widely by property type and from one lender to another. The maximum amounts are decided on by a bank’s risk committee and written into their credit policies. For example, if a borrower wants to get a loan for a piece of raw land, the maximum loan-to-cost for a lender may be 50% But, if the same borrower were to request a loan for a grocery store anchored retail center, the maximum loan-to-cost could be 80% because it is a far less risky property type.

How To Calculate The Loan To Cost Ratio

The formula used to calculate the loan-to-cost ratio (LTC) depends on whether an investor is purchasing an existing property or if they plan to construct a new one.

For the purchase of an existing property, loan-to-cost is calculated as the loan amount divided by the purchase price. So, for example if a property has a purchase price of $1,000,000 and a loan amount of $800,000, the resulting loan-to-cost is 80%. It could also work the other way if the loan amount is not known. For example, if we know the purchase price is $1,000,000 and the maximum loan-to-cost is 80%, the maximum loan amount is $800,000.

In a construction project, the loan-to-cost ratio is calculated as the loan amount divided by the total cost of the project – with the cost inclusive of land and all vertical construction. So, if an investor knows that the loan amount is $2,000,000 and the total construction cost is $2,500,000, the resulting loan-to-cost is 80%.

What Does Loan to Cost Tell Lenders and Borrowers?

Loan-to-cost is ultimately a measure of risk – the higher the allowable LTC the more risk a lender is willing to take. Higher LTCs are usually reserved for the safest property types and most well capitalized borrowers.

If the maximum loan-to-cost is lower, it means that the lender views the property type and/or borrower as riskier, so they are willing to lend less against it. For example, land, hotels, restaurants, and new development projects are all considered to be on the riskier end of the spectrum, so the loan-to-cost is going to be lower, which means that the required down payment is higher.

What is the Loan to Value Ratio?

Loan to value (LTV) is another ratio that is commonly used to size real estate loans. As the name implies, it is the ratio of a loan amount to the property’s value.

For example, if a rental property had an appraised value of $1,000,000 and the maximum loan to value is 80%, then the maximum loan amount for this property is $800,000.

LTC vs. LTV in Commercial Real Estate Financing

When comparing LTV vs. LTC, there is one important fact to remember – cost and value are not always the same. Again, cost is most closely associated with the purchase price of a property while value is most commonly associated with an approved, third-party appraisal.

For example, an investor could be under contract to purchase an investment property for $10,000,000 and their lender has indicated they are willing to lend 75% of the cost or $7,500,000. But, prior to closing, the actual appraisal comes in for the property and the value of the property is determined to be $9,500,000. The same 75% LTV means that the maximum loan amount would be $7,125,000.

The key point here is that lenders will use both the LTV and LTC ratios while underwriting a loan request and will often lend against the lower of the two. So, in real estate investing, individuals need to be prepared for the surprises that can come with this approach. In the example above, there is a $375,000 difference between the two supportable loan amounts. Because lenders go with the lower of the two, this means that the investor might need to put an additional $375,000 of equity into the deal that they may or may not have been prepared for.

Why Should CRE Investors Know About the LTC Ratio?

There are three things that CRE investors should know about the LTC ratio.

First, going back to the question that opened this article, it can provide an avenue to answer the question of how much financing can be obtained. This is a very important input into a financial model and can drive investment returns.

Second, it can vary widely from one lender to another and is often used as a signal to indicate an “appetite” for certain types of loans. For example, a hard money lender may set a maximum LTC of 85% for a construction loan while a more traditional lender may set the LTC for the same type of loan at 75%.

Finally, LTC can also be a signal to investors about the loan terms that a lender may require. For example, a lower LTC may be a signal that the interest rate could be higher or that a lender may be unwilling to roll the closing costs into the total loan amount.

So, when evaluating their financing options, investors should start by inquiring about basic loan terms like the LTC and LTV ratios to determine the total amount of the loan that they may be able to receive in a deal. The stated amounts can drive investment strategy and the decision to go with a more conventional loan versus something more aggressive like a hard money loan.

Interested in Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners. 

If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.

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