Learn about Loan to Value (LTV) and how it plays a crucial role in determining the loan amount for commercial real estate lending. Additionally, understand the significance of commercial loan analysis and underwriting during the lending process.
In this article:
- Understanding Loan to Value (LTV) for Property Lending
- Appreciating Concepts: Single Credit Tenant
- Understanding the Difference Between LTV and LTC in Property Lending
- A Look at Cash-Based Lender Priorities
- The Commercial Loan Analysis: How Banks Evaluate the Viability of a Proposed Loan
- Asset-based Lenders
Understanding Loan to Value (LTV) for Property Lending
Before lending on a property, a bank makes sure that the amount of the loan can be covered by the sale of the building. This does not mean that the bank can lend on a building’s full value at the time that the loan is made. Although a building may be worth a certain amount at that time, there is no guarantee that the bank would be able to get that amount years down the line, as buildings can devalue over time. Furthermore, a bank may not be able to get the full market value for a building in the process of foreclosure.
A bank will therefore only lend a percentage of the present value of the property. The percentage of the value that each bank lends on, is referred to as its Loan To Value, or LTV. A bank that lends on a 75% LTV, will lend $750,000 on a building valued at $1,000,000. In this way even if the building devalued at the time of foreclosure by 25% the bank can still recoup the full amount of the loan.
The LTV can vary between banks. The determining factor in this number is the level of risk that a lender is willing to take. A bank that lends at a high LTV risk, should the building devalue more than the percentage of the LTV, it will not be able to make back its money.
For example, a bank that lends at 80% LTV, would lend $800,000 on a building valued at $1,000,000. However, to actually purchase this building, the buyer had closing costs of $50,000 for a purchase price of $1,050,000. Even though a loan of $750,000 is 75% of $1,000,000 purchase, it works out 71.4% loan to cost. If this building would decrease in value by 25%, the bank will only be able to recoup $750,000 of the loan, thereby taking a loss of $50,000. Thus the lower the LTV, the safer the loan.
The common industry standard is 75% LTV. More conservative banks lend at 70% LTV and more aggressive banks are willing to lend up to 80% LTV.
Appreciating Concepts: Single Credit Tenant
At times, a lender will lend up to, and even beyond, the value of the property. This is in the case of the single credit tenant. A credit tenant, like Wal-Mart, often has a long-term lease (20 years or more) that is NNN. Under that arrangement, the landlord knows exactly how much he is going to get paid and is confident that he will indeed get paid. Since the tenant is a credit tenant such as Wal-Mart, the lender is very confident that the borrower will not default. When the only tenant for a property is such a tenant, a lender may lend to the landlord and even structure extremely high loans, sometimes exceeding the value of the building. The lender does this since the loan is backed up by the credit of a strong tenant such as Wal-Mart.
Understanding the Difference Between LTV and LTC in Property Lending
LTV and the LTC are two measures that a bank uses to determine the loan amount. The LTV is concerned with the value of the building at the time that the loan is made, while the LTC is concerned with the amount that the owner is paying for the building. A bank decided on each of these numbers based on different concerns, as explained. Usually, there is no significant difference in whether the bank uses the LTV or the LTC. This is because the cost of the property (LTC) is usually the same as the present value (LTV) of the building. A bank, therefore, lends 75% of the value of the building which is also 75% of the cost.
However, there are times when the value of the building is incongruent with the actual cost. An investor may overpay on a building in the belief that he can turn the building around and increase its profits over time. As explained above (10.1), a bank will only lend based on the actual current value of the building. In this case, the LTC is higher than the LTV, for the cost is higher than the value. Because both the percentage that a bank chooses for its LTC and that of the LTV are based on separate legitimate concerns, a bank will take both numbers into account and lend on whichever is less. In this case, the bank will only lend on the LTV, which is less than the LTC.
In the reverse scenario, an investor can get a bargain, and pay a price that does not reflect the real value of the property. For example, an investor buys a property worth $1,000,000, but somehow gets a great deal and actually pays only $900,000. In this case, 75% LTV, the percentage of the actual value of the building, is $750,000, for the building is actually worth $1,000,000. But the 75% LTC, is only $675,000, 75% of the cost of the building. Because the bank wants the owner to put in at least 25% of his own resources, it will insist on going with its 75% LTC percentage, and will not lend more than $675,000 (75% of $900,000).
Considerations When Determining LTV Through Property Appraisals
In order to ascertain the LTV in each particular case, banks order appraisals done on a property to find out its value. Some banks prefer one of the methods of appraisals delineated there and some just use the method which yields the lowest amount in each case.
A Look at Cash-Based Lender Priorities
Cash-based lenders are in the business of managing money, not buildings. In general, a bank would prefer to avoid foreclosures. Foreclosure is not an assurance that they will get the full value for their building, and they are additionally saddled with the responsibility of managing the property until it can be sold.
Foreclosure can be a lengthy process. When a building goes into foreclosure the primary goal of the bank is not to make a profit, but to sell the property as fast as possible in order to recoup their loss. Initially, the building is put up for sale on the courthouse steps. The lender opens the bidding at the lien amount (the balance left on the loan), and the highest bidder gets the property. If there are no other bidders, the bank will take over the property and sell it. (It is through this process that investors are sometimes able to buy properties at below-market value.) Banks are more interested in getting back their initial investment than profiting from the sale.
The Costs of Managing a Foreclosed Property
When a bank starts foreclosure proceedings, it may still be a considerable amount of time before it is able to sell the property. During this time, the bank, as the new owner, must continue to manage the building so that the building can produce cash to pay for the mortgage. Since banks are not primarily in the business of managing property, it can be more expensive for a bank to run a building than for a private landlord. For example, a private landlord may run the day-to-day aspects of the building himself, whereas the bank will have to hire management for the building. A landlord may have a deal worked out with an insurance company due to his many land holdings, whereas the bank will have to pay the prime rate.
This is another reason that a bank, when considering whether to lend on a building, will calculate the expenses at its highest possible amount. While the owner may claim not to have so many expenses, the bank prepares for the possibility of repossessing the building. If that happens, it will have to run the building with its own resources.
The Commercial Loan Analysis: How Banks Evaluate the Viability of a Proposed Loan
After going through all of the calculations that affect the loan, the bank will create a commercial loan analysis. The commercial loan analysis is similar to an income and expense sheet, but its focus is on the viability and amount of the proposed loan. It includes the result of the bank’s research and the calculations described above.
In addition, there is a section on the commercial loan analysis called ‘underwriting’. ‘Underwriting’, in general financing usage, refers to the process by which lenders determine the profit of a building by backing up actual numbers and using known formulas to calculate expenses (such as for vacancy). In the commercial loan analysis, the underwriting column contains projections, based on past performance and on established formulas, of future expenses.
A cash flow lender is primarily focused on the steady flow of cash that the building can produce. While a cash flow lender would foreclose on a building would it come to it, it is not his first choice.
Asset-based lenders look primarily at the value of a property (its assets) and make a risk decision based on what it can be sold for in the event of foreclosure, without taking the potential cash flow into account. Most asset-based lenders are private lenders who lend on vacant buildings, obtaining their money from private funds. They lend at higher interest rates than those of a bank in order to compensate for the greater risk they are taking.
Asset-based lenders generally lend on a building that is worth much more than the amount of the loan. Should the borrower fail to make his payments, the lender can foreclose and sell the building, thereby making more than he initially lent. Someone looking to purchase a building for $1,000,000 and only needs to borrow $500,000 might go to an asset-based lender for the loan. The asset-based lender agrees since the building is worth double the amount of the loan. Should they foreclose, they make $500,000 profit on the deal.
Still, the inherent risks involved in insuring the whole loan amount with foreclosure alone keep most banks away from this type of lending.
- What is LTV, and how is it calculated?
LTV stands for Loan to Value, and it is the percentage of the value of a property that a bank is willing to lend on. It is calculated by dividing the amount of the loan by the current value of the property.
- How does a bank determine the LTV?
The LTV is determined by the level of risk that the bank is willing to take on. A more conservative bank will lend at a lower LTV, while a more aggressive bank may lend up to 80% LTV. The industry standard is 75% LTV.
- What is the difference between LTV and LTC?
LTV is concerned with the value of the property at the time the loan is made, while LTC is concerned with the amount that the owner is paying for the property. The bank will determine the loan amount based on whichever is less. If the cost of the property is higher than its present value, the bank will lend based on the LTV. If the cost is lower than the present value, the bank will lend based on the LTC.