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Commercial Mortgage 101: Loan-to-Value Ratio

Overview

Most investors believe that the maximum loan-to-value ratio (LTV) offered by a lender applies to every single property, regardless of net operating income or debt coverage ratio. This is hardly the case, as properties in Southern California rarely achieve the maximum LTV offered by a lender due to high property values and strict DCR requirements. LTV is closely tied to an important concept, which is leverage, and most investors understand that higher leverage can result in less cash flow; since a greater portion of the property’s net operating income is being used to make the mortgage payments.

Definition

The loan-to-value ratio is the ratio between the loan amount and the lesser of the property’s appraised value or purchase price. Examples of when the appraised value may fall below the purchase price for an investment property may include the following: the cost of deferred maintenance, where the “cost to cure” can result in a reduced value; the current rents may be either higher or lower than market rents, resulting in a perception of either inflated or diminished value; the property may be suffering from functional obsolescence or may include non-legal or non-conforming units, which will further erode the NOI and result in a lower value.

  • The loan-to-value ratio is one of the more simple ratios to calculate:

    Loan Amount / Market Value = Loan-to-Value

    The loan amount that a property can support is based on a number of factors, most notably net operating income, and debt coverage ratio. The market value for a property, as explained above, is the lesser of appraised value or purchase price.

  • Lenders use the loan-to-value ratio to mitigate the risk that an investor will encounter financial difficulties with the property due to mismanagement or personal problems. In Southern California, most apartment loans feature a maximum 75% LTV for purchases.

    However, refinances can mean 70% or less, and other property types can mean 65% or less. On the other hand, high LTV financing is available (up to 90% or more in some cases), but the higher LTV means higher risk to the bank, which means higher interest rates. Unless a property really does have significant upside, most investors are better off with financing using a lower LTV; that way, the property will generate a steady and sufficient cash flow to pay down debt.