Feb 27, 2024# How to use Loan to Value when analyzing a real estate property?

The loan to value ratio (LTV) is a common metric used in commercial real estate analysis and computations. LTV represents the amount of loan given by the bank compared to the value of the commercial property. It is calculated by dividing the loan amount by the value of the property and expressed as percentage. In this post, we review the LTV formula, how to calculate it, what is its significance, and how it is used in real estate financing. We include examples of how to use the LTV ratio in calculations.

The Loan to Value (LTV) expresses the ratio of the loan amount to the property value as a percentage. This simple metric is used by appraisers to determine the market capitalization rate or by lenders to determine the size of the loan and to quantify credit quality of existing loans.

The LTV ratio measures the cushion between outstanding loan amount and the property value. Higher LTV implies higher risk for the lender and vice versa. In underwriting, the LTV always appears together with other underwriting metrics such as the debt service cover ratio (DSCR or just DCR) and the debt yield ratio as these determine the feasibility of the financing.

The loan to value (LTV) is the (principal) amount of the loan divided by the property value:

$$LTV = LA/PV$$

The LTV is expressed as a percentage rate. To calculate the loan amount for a known or given LTV rearranging the formula yields

$$LA = PV*LTV$$

Lenders use this formula to determine the loan amount for specific financing requirements.

First, a lender estimates the value of the property or hires an appraiser to provide a valuation. This property value is then used in the LTV formula.

As an example, lender determines the LTV for a property appraised at $4,000,000 and a loan amount of $1,000,000 as 1,000,000/4,000,000 = 25%.

In most cases, the LTV is known and we wish to determine the loan amount. Suppose credit policy requires maximum LTV of 75% and the property value is $10,000,000. Here, using the rearranged LTV formula gives 10,000,000 x 75% = $7,500,000 as the loan value.

Bank or lenders typically use the minimum of property appraised value when calculating LTV. For construction or renovation projects, the denominator of the LTV formula includes total project costs instead of just property value. In case the loan is solely to cover construction costs, one uses the loan to cost ratio (LTC) rather than the LTV.

If the LTV ratio equals 100% this means the outstanding loan amount equals the property value. LTV higher than 100% implies the property is worth less than the outstanding loan amount which should not be the case. Contrary, LTV lower than 100% means the property is worth more than the outstanding loan amount.

Lenders require LTV be much lower than 100% to have a safety margin. Actual LTV vary significantly depending on the property type, borrower credit risk, and on the bank’s internal credit policy. Usually, LTV ratios range from 40% - 70%.

Now we look at examples of how the LTV is used to calculate the maximum loan amount, how appraiser use LTV to determine the market cap rate, and finally, how to calculate cash-on-cash return using LTV and weighted average cost of capital.

The LTV is commonly used by lenders in a maximum loan analysis which determines the maximum loan amount a lender can support. Here is an example of a maximum loan analysis.

Property Value at 8% Cap Rate is $2,500,000

LTV is 75% -> Max LTV loan is $1,875,000

NOI is $200,000

DSCR 1.25

Allowable Debt Service = $160,000

Max DSCR Loan = $1,719,766

Max Supportable Loan is $1,719,766

The analysis above first calculates a maximal LTV loan as $1,875,000 using the LTV formula. Then, maximal supportable loan is calculated using DSCR, resulting in $1,719,766. Lender would take the smaller of the two values and the maximal supportable loan amount would be $1,720,000 after rounding up.

While appraising, one would often use the LTV in a band of investment calculation, which is a weighted average cost of capital calculation that helps determine the market capitalization rate. In the formula below, Rp is the free return on the property, Rd is return to the debt on the property, and Re is the return on the levered equity in the property, respectively.

$$R_p = LTV \times R_d + (1 - LTV) \times R_e$$

Appraisers survey local lenders (to extract typical loan terms for subject property) and investors (to find out the typical required cash-on-cash returns) in order to determine overall capitalization rate for a given market and property type.

Example: For the subject property, lenders underwrite loans at 75% LTV, amortized over 25 years, and at an interest rate of 5%. This results in a mortgage constant of 0.07015. Investor survey shows cash-on-cash return required by most investors is at 11%. The over capitalization rate is estimated as:

$$R_{p} = 75\% \times 0.07015 + 25\% \times 0.11 = 8\%$$

The above analysis is often used during slow market periods or in tertiary markets where it is hard to find extensive market data.

Employing the weighted average cost of capital formula is also useful to calculate cash on cash returns in case we have insufficient information or data. For this purpose, one rearranges the formula to solve for the return on equity (ROE).

$$R_e = \frac{R_p - LTV \times R_d}{1 - LTV}$$

We can use this formula to solve for cash on cash using LTV, the return on debt, and the return on the property.

Example: Considering the example of the previous section. Note the mortgage constant 0.07015 is our return on debt, and the overall capitalization of 8% is our return on the property. Solving for the cash on cash return on equity yields

$$R_E = \frac{0.080113 - 75\% \times 0.070150}{25\%} = 11\%$$

Hence, LTV ratio together with the mortgage constant and the cap rate can be used in a swift calculation of the cash on cash return.

The loan to value ratio is commonly used in CRE and is an integral metric for real estate analysis involving financing and acquisition. This post reviewed the definition of LTV, how to calculate the LTV ratio, and its meaning. We showcased several application of using LTV in calculating maximum supportable loan, the band of investment calculation, and the weighted average cost of capital calculation.