LTV vs LTC: Debt in Commercial Real Estate Projects

Now that we’ve covered the various components of financing for a commercial real estate transaction – the “capital stack” – let’s take a look at LTV vs LTC, and specific aspects of debt in the capital stack. Though lending in commercial real estate is more complex than in single-family transactions, and the underwriting process more onerous, the basic premise is the same: the lender assesses how safe it is to lend to a prospective borrower, and sets terms accordingly (or opts not to issue a loan at all).

Leverage

From an investor’s perspective, leverage is the practice of using borrowed money for the acquisition, development, or improvement of an asset. In other words, seeking greater absolute returns by deploying other people’s money. From a lender’s perspective, the greater the leverage, the greater the risk, as the borrower is correspondingly putting less of their own capital on the line.

Here are a few of the key metrics lenders use to evaluate leverage (and thus risk). As a co-investor, these are figures you should be aware of as well.

LTC – Loan to Cost Ratio

Loan-to-cost (LTC) ratio is the dollar amount of a commercial real estate loan divided by the cost of the project, inclusive of acquisition cost (where applicable), construction expenditures, and various fees (e.g. attorney’s fees, appraisal, etc.). The LTC ratio is most often specific to construction loans, and allows commercial real estate lenders to determine the risk of offering a construction loan.

LTV – Loan to Value Ratio

Loan-to-value (LTV) is a close relative of LTC, but they are not interchangeable. LTV is simply the ratio of the loan amount to as-is fair-market value of the property. This value is a straightforward calculation in the case of an existing asset; while an appraiser may be involved, as-is fair-market value of an asset can be estimated by dividing Net Operating Income (NOI) by a selected cap rate. This is called the Direct Capitalization method. The situation is more difficult in the case of an asset that is yet to be built. By definition, such an appraisal would have to involve an estimate of future market conditions in order to value the asset post-completion, and appraisers take into account market data, sales and rent comparables of similar properties, and the pattern and duration of the property’s anticipated net income stream, discounting to present value.

Multifamily Community in San Antonio, TX with a 75% LTV vs 65% LTC

Debt Service Coverage Ratio (DSCR)

Debt service coverage ratio (or DSCR) is one of the key metrics utilized in evaluating commercial real estate transactions and finance decisions. At a basic level, the ratio operates in the same way for real estate companies as it does for individuals paying down a mortgage: it is the net income available to service a loan, per unit time. Whether an individual or a company, the ratio is used as a measure of “creditworthiness” or, conversely, as a measure of risk for the prospective loan issuer.

In the case of commercial real estate lending, the ratio can be expressed as DSCR = NOI / Total Debt Service, where NOI is the familiar Net Operating Income figure (Effective Gross Income less Operating Expenses) and Debt Service captures both interest payment and, for amortizing loans, scheduled repayment of principal for the unit of time being considered.

A debt service coverage ratio of greater than 1 indicates that property cash flows are sufficient to service the loan, however most commercial lenders require a significantly higher minimum DSCR in order to originate a loan, typically in the range of 1.15-1.35. Non-bank lenders, or “hard money lenders,” may be somewhat more forgiving of a DSCR closer to 1. In either case, the DSCR at which lenders are willing to lend will depend somewhat on market conditions and macroeconomic trends, all factoring into the perceived risk of the particular loan; in a healthy market during an economic upswing, a lender may be willing to lend at a DSCR closer to 1. Other aspects of the borrower’s situation may also factor into the DSCR required by the lender, such as their track record in sustaining NOI and making timely payments on past loans.

LTV vs LTC & DSCR in Commercial Real Estate Lending

Lenders combine loan-to-cost, loan-to-value, and debt service coverage ratio (DSCR) to assess the risk of the borrower and the borrower’s project. The higher the LTV and LTC, the higher the proportion of the project cost that is being financed by the loan, and thus the riskier the loan. The higher the DSCR, the more comfortably the borrower can service the loan, and thus the less risky the loan. Lenders typically operate with a minimum threshold DSCR, and max LTV and LTC they are willing to lend at, and these ratios are typically instrumental in determining the interest rate offered.

Conclusion

When evaluating potential debt syndication offerings for our platform, the EquityMultiple Real Estate Team pays careful attention to these ratios. Considered alongside the net rate of return, LTC and LTV help us hone in on syndicated debt investment opportunities that offer attractive risk-adjusted return to our investors.

While these metrics are first considered in the context of a potential loan, they have repercussions up and down the capital stack – equity investors in a real estate project should also take a close look at the leverage situation when considering a potential investment. The more capital the Sponsor contributes to the project – i.e. their own equity – the more skin they have in the game, and the more direct incentive the Sponsor has to diligently execute on their business plan. This “skin in the game” is what’s left over after leverage and LP equity. At EquityMultiple, we typically require Sponsors to contribute at least 10% of the equity in a project.