Before you invest in commercial real estate, you must understand the loan-to-value ratio (LTV). It’s what investors use to gauge their leverage and what lenders use to gauge their risk. Without it, you won’t be able to fully assess a potential deal or compare it with alternative investments.
What is loan to value (LTV) ratio in commercial real estate?
In commercial real estate, the loan-to-value ratio (LTV) compares the size of a mortgage to the value of the property it is financing. Think of it as the inverse of a down payment. If the down payment is 20%, the LTV would be 80%.
LTV vs. debt yield vs. DSCR vs. cap rate
How to calculate LTV
To calculate LTV, divide the loan amount by the property’s appraised value. Then multiply by 100 to get a percentage.
LTV formula
Here’s the LTV formula:
LTV = (Loan Amount / Property Value*) x 100
*Typically the lower of the property’s appraised value or purchase price
Sample CRE deal LTV calculation with market-based valuation
Let’s say you find an office building valued at $10M based on market comps. Assuming you can get a commercial mortgage for $7M, your LTV would be 70%. Here’s the math:
$7M / $10M = 0.7
0.7 x 100 = 70%
Now imagine that as the closing date nears, the office building’s appraised value comes in lower at $9M. In this case, your LTV would adjust to about 78%:
$7M / $9M = 0.78
0.78 x 100 = 78%
However, if you wanted to maintain a 70% LTV, you could try to lower the loan amount from $7M to $6.3M (i.e., increase the down payment from $2M to $2.7M):
$6.3M / $9M = 0.70
0.70 x 100 = 70%
Calculation mistakes to avoid
Here are some common calculation mishaps to avoid:
- Using the wrong property value. Since the property serves as collateral on the loan, many commercial mortgage lenders calculate LTV with the lower of the purchase price and the appraised value.
- Ignoring updated valuations post-closing. Property values tend to fluctuate, which could impact your LTV over time. Track the property’s value to know its current LTV.
- Excluding mezzanine or secondary financing. If there’s any junior or mezzanine debt in the deal’s capital stack, account for it in your “combined LTV” or CLTV. Otherwise, you’ll get a skewed sense of your leverage.
Factors that influence the LTV ratio
Now that you know what LTV is and how to calculate it, here are some factors that influence it:
Appraisal methods
How you appraise a property can affect its value and the LTV by extension. For example, there are three main appraisal methods in CRE:
- The income approach divides the property’s net operating income (NOI) by a local market cap rate to arrive at an estimated value.
- The sales comparison approach values property based on what similar properties nearby have sold for recently.
- The cost approach bases property value on what it’d cost to replace the property. It’s calculated by subtracting any depreciation from the land value plus construction costs.
Impact of property condition, location, and asset class
The property’s condition, location, and asset class also play a role in its value.
For example, many buildings are classified as Class A, B, or C depending on their proximity to urban centers, age, condition, and overall desirability. The more desirable the property, the more valuable it is and the higher the resulting LTV (all else equal).
Borrower financials and credit profile considerations
Your credit profile determines how willing commercial real estate lenders are to lend to you and under what terms.
Generally speaking, the better your credit, the higher the LTV you can qualify for. This is because commercial lenders tend to offset risk with collateral. The less risk you present, the less collateral you may be required to put up. Demonstrate your creditworthiness by sharing your credit report, cash reserve amounts, and investment track record.
Market volatility and capitalization rate movements
The broader market also impacts LTVs. For example, fluctuating interest rates have a direct influence on how much you can afford to borrow on a property, which affects LTV. Similarly, compressing or expanding cap rates can impact property values and thereby change LTV.
The key is to keep a pulse on market dynamics so you can maintain an accurate LTV estimate.
Acceptable LTV ratios: What lenders and investors look for
Acceptable LTV ratios vary by lender, market, and borrower. However, most CMBS loans permit a maximum LTV of 75%, meaning you can borrow up to 75% of the property’s value. Another way to put this is, you must make a down payment of at least 25%. This shows you have skin in the game and helps protect lenders if you default on the loan.
For investors, there is no standard LTV target. The higher your LTV, the more leverage you have, which means more risk but higher potential returns. The lower your LTV, the less leverage you have, which means less risk but lower potential returns.
Pros and cons of high vs. low LTV
Let’s explore the pros and cons of high vs. low LTVs in more detail:
Pros of high LTV
- Maximizing leverage: Lets you acquire more property with less upfront capital, freeing cash for other investments
- Higher potential IRR: Boosts returns on equity when property values rise or rental income increases
Cons of high LTV
- Default probability: Increases the chance of default since higher debt requires larger mortgage payments
- Risk of going underwater: If property values drop, your property could end up being worth less than what you owe on the commercial mortgage
Pros of low LTV
- Conservative risk profile: Lowers the likelihood of you losing the property during downturns since you owe less relative to its value
- Flexibility: Gives you more borrowing capacity later (via cash-out refinances) for renovations, expansions, or new acquisitions
Cons of low LTV
- Capital inefficiency: Ties up more of your own money, lowering the overall return on your invested capital
- Dilution: If you bring in partners to raise the extra equity, your ownership stake and profit share may shrink
Best practices for managing LTV in CRE deals
It’s one thing to understand how LTV works; It’s another to manage it effectively. Follow these best practices when analyzing your next deal:
Structure loans for optimal LTV and cash flow
A high LTV can boost your potential returns, but let it rise too high, and you may take on too much risk. Plus, a high LTV means you’ll have larger monthly debt payments cutting into your cash flow. As a result, you must balance cash flow and leverage to arrive at an optimal LTV.
Plan for market shifts with a sensitivity analysis
Run stress tests to see how changes in cap rates, interest rates, and other metrics could impact LTV. If you forecast market shifts ahead, take these into account before settling on an LTV.
Build exit and refinance plans with LTV targets
Whether you plan to sell or refinance, set a target LTV at which you want these capital events to take place. For example, you could target a sale once your LTV reaches 30% or a cash-out refinance once it reaches 20%.
Monitor LTV over the lifecycle of the asset
Regularly monitor your LTV post-closing. This can help you stay on top of how much equity you own and what your refinancing options are.
Tools and models to analyze LTV
Fortunately, there are many ways to analyze LTV:
CRE valuation models that integrate LTV outputs
Investment management platforms like Agora can calculate LTV for you. That way, you can easily track various investments’ LTVs in real time and share them with investors and stakeholders (along with other key metrics).
Excel-based and automated LTV calculators
Even basic spreadsheet software like Microsoft Excel can calculate LTV for you. A pre-built LTV calculator template that uses the LTV formula can be a great resource for quick LTV checks.
LTV tracking across portfolio or fund level
As a CRE sponsor or GP, you may manage multiple properties. Calculating your portfolio-wide LTV or average LTV is a great way to gauge your overall leverage and ensure you’re complying with securities regulations.
Conclusion
Mastering the loan-to-value ratio (LTV) is essential for making informed, profitable decisions in commercial real estate financing. By understanding how it’s calculated, what influences it, and how to manage it over time, you’re better positioned to identify financing deals that balance risk and potential returns.
Whether you aim for a high or low LTV, the key is to match your financing strategy with market conditions and your long-term investment goals.
