Loan to Value, or LTV, is the ratio of the loan amount divided by the value of a property:
LTV=Loan Amount/Property Value
Let’s assume a property is worth $1 million and the Borrower wants a loan of $750,000. The LTV would be calculated as follows:
LTV=.75 or 75%
Typically, a lender is willing to loan more money against a stable cash flowing property like a multifamily building versus non-cash flowing raw land. The U.S. Office of the Comptroller of Currency, or OCC, publishes guidelines for national banks to follow in which the LTV for multifamily is capped at 85% and the LTV for raw land is capped at 65%.
Using the appropriate OCC caps multifamily property and a piece of raw land both valued at $1 million, the loan amount would be calculated as follows:
65%= Loan Amount/$1,000,000
Loan Amount = $1,000,000 x 65%
Loan Amount= $650,000
85%= Loan Amount/$1,000,000
Loan Amount = $1,000,000 x 85%
Loan Amount= $850,000
The example above shows how lenders use predefined LTV caps to limit risk. In commercial lending, underwriters may further adjust the loan amount and deviate from the maximum LTV in its guidelines to account for other conditions impacting a potential loan. You may have noticed in lender advertising, the phrase “up to 85% LTV” to allow for appropriate adjustments as warranted.
So why do lenders care of about LTV? There are at least two reasons. First, LTV tells us something about how much “equity” or skin in the game the borrower has on a given property. If the borrower fails to pay the lender back, the lender will foreclose on the property and sell it to recover as much as it can on its loan. The borrower very likely will lose their equity which is the difference between the property value and the loan amount. Second, and related to the first, the LTV describes how much cushion the lender has on the loan before they might lose some of their loan principal. It is not free to foreclose on and resell a property. So the lender wants to know that they have sufficient cushion to protect against the transaction costs associated with foreclosing and reselling a property along with any reductions in property value due to deferred maintenance or changed market conditions.
While LTV is a traditional measure of risk in making a loan, many underwriters point out that the value of a cash flowing asset is commonly valued based on the capitalization rate, or cap rate, and even small changes in cap rates can impact a property’s value and thus the LTV. In a separate blog, we will compare DSCR, LTV and Debt Yield.