Loan-to-value ratios (LTV) are widely used in commercial real estate. They are calculated by dividing the loan amount by the value of the property and expressed as a percentage. This article explains the formula for loan-to-value ratio, how to calculate LTV, its importance, and its use in real estate finance. It also explains how to use LTV ratios in a maximum loan analysis, and provides examples of calculating cap rates and cash-on-cash returns.
What is the loan-to-value ratio?
Loan-to-value ratio (LTV) is the ratio of the loan amount to the property value. Lending institutions widely use this ratio to size loans and measure the credit quality of existing loans. Appraisers can also use this ratio to determine market-to-market ratios using the investment band methodology. Additionally, this ratio can also be used in the weighted average cost of capital formula to quickly estimate the cash-on-cash return on a property.
The loan-to-value ratio indicates how much room there is between the loan balance and the property value. The smaller the difference between the loan amount and the property value, the higher the risk for the lender. Conversely, the larger the difference between the loan amount and the property value, the lower the risk for the lender. The loan-to-value ratio is used by lenders along with other underwriting ratios such as the debt service coverage ratio (DSCR) and the debt yield ratio.
Loan-to-Value Ratio Calculation Formula
Loan-to-value ratio (LTV) is the principal amount of the loan divided by the estimated property value.
The loan-to-value ratio is expressed as a percentage and tells you how much room there is between your loan amount and the value of your property. If you know your LTV ratio, you can rearrange the LTV formula to find your loan amount.
This relationship allows lenders to determine the amount they will loan for a property based on specific loan-to-value requirements.
How to Calculate Loan-to-Value Ratio
To calculate the loan-to-value ratio, a lender must first estimate the value of the property. In most cases, a lender will hire a third-party appraiser to perform an appraisal of the property they're considering. This appraisal is then used to calculate the loan-to-value ratio.
For example, say your property is appraised at 10,000,000 and your loan amount is 8,000,000. In this case, your loan-to-value ratio is 8,000,000 / 10,000,000, or 80%.
Usually the LTV is known and needs to be determined. For example, let's say the lender's credit policy states the maximum LTV is 70% and the property is valued at 10,000,000. In this case, the loan amount using the LTV method would be 10,000,000 x 70% or 7,000,000.
Since an appraisal is only an estimate of market value, lenders will typically use the lower of the appraisal value or the actual purchase price of the property. For example, if the purchase price of a property is 7,500,000 and the appraisal value is 7,600,000, the bank will use 7,500,000 to calculate the loan to value ratio.
For construction loans, lenders will instead use a loan-to-cost ratio (LTC), which uses the total cost of the project in the denominator instead of value or purchase price.
What is Loan to Value?
A loan-to-value ratio of more than 100% means the property is worth less than the loan balance. A loan-to-value ratio of less than 100% means the property is worth more than the loan balance. A loan-to-value ratio of 100% means the property is worth equal to the loan balance.
Typically, lenders require a loan-to-value ratio much lower than 100% to allow for a safety margin in case something goes wrong. The actual loan-to-value ratio will vary depending on the type of property, the borrower's credit risk, and the bank's own internal credit policy guidelines. Generally, loan-to-value ratios range from 50% to 80%.
LTV calculation example
Let's take a look at how commercial real estate professionals use loan-to-value ratios. First, we'll see how banks calculate maximum loan amounts using a variety of methods, including the loan-to-value ratio method. Then, we'll see how appraisers use the investment band method to determine market cap rates. Finally, we'll use the weighted average cost of capital to calculate cash-on-cash returns. The loan-to-value ratio is a key component of all of these calculations.
How to Calculate Maximum Loan Using LTV
Loan-to-value ratios are widely used by lenders in maximum loan analysis. In a maximum loan analysis, several methods are used to calculate the maximum loanable amount. The lender then takes the lowest result from all the calculations. A typical maximum loan analysis includes:
In the above analysis, we use the LTV approach to calculate the maximum loan assuming a loan to value ratio of 75% and a property value of 1,250,000, which results in a maximum loan amount of 937,500.
We then use the debt service ratio to calculate the maximum loan amount, which results in a maximum loan amount of 859,883.
Finally, take the lesser of these two values to determine the maximum loan amount, which in practice is usually rounded down to 859,000.
How to Calculate Cap Rate Using LTV
Appraisers frequently use loan-to-value ratios in their investment band calculations, which are a weighted average cost of capital calculation used to determine market capitalization ratios with limited information.
Appraisers can arrive at a market-wide capitalization rate by researching local lenders and investors. Lender research tells the appraiser the typical loan terms for the subject property, and investor research tells the typical cash-on-cash return required. Using this data, the appraiser can calculate an overall capitalization rate.
For example, if a lender is willing to underwrite a loan on a subject property with a loan-to-value ratio of 75%, a 25-year amortization period, and a 5% interest rate, then the mortgage constant would be 0.07015.
Let's assume that the cash-on-cash return required by investors is 11%. This gives us enough information to estimate the overall capitalization rate.
This type of analysis is often used by appraisers when market data is difficult to find, which can occur during slow periods in a market cycle or in tertiary markets where transaction volume is not as high.
How to use LTV to calculate cash on cash
The weighted average cost of capital formula can also be used to calculate cash-on-cash return with limited information. To accomplish this, rearrange the formula to solve for return on equity. Then use the loan-to-value ratio, return on debt, and return on equity to solve for cash-on-cash.
For example, let's use the same data as the previous investment band problem, but this time we want to find the return on equity when using leverage. The mortgage constant in this example is 0.07015, which is the return on debt. The total capitalization rate we want is 8%, which is the return on property. We can now use the formula above to find the return on equity, or cash-on-cash return:
As shown above, you can easily calculate your cash-on-cash return using the LTV ratio, mortgage constant, and cap rate.
Conclusion
Loan-to-value ratios are widely used in the commercial real estate industry. In this article, we've defined loan-to-value ratios, reviewed how to calculate LTV ratios, and explained what they mean. Finally, we've discussed several applications of loan-to-value ratios, including maximum loan-to-value analysis, investment band calculations, and weighted average cost of capital.