The loan to cost (LTC) ratio is one of the major tools professionals use in commercial real estate financing. We use LTC in real estate to determine how much money an investor can borrow to finance the acquisition, construction or rehabilitation of a property.
What Is the Loan to Cost Ratio?
The LTC formula is:
LTC = Loan Amount / Total Project Cost
As you can see, the LTC formula is easy to calculate. For example, let’s say that the total project cost is $10 million and the loan amount is $7 million. We would then calculate LTC ratio as follows: $7M divided by $10M = 70%. Though it is not particularly necessary, you may visit this loan to cost calculator if you wish.
However, this relatively simple formula masks two complicating factors:
- You must carefully estimate total project cost using accurate and complete cost data. As you’ll see below, many line items go into the total project cost. Failure to include all costs shortchanges the borrower on the amount it can borrow. Overstating the cost can cause the lender to lend too much money for the value of the finished project. Consequently, this assumes added risk should the borrower default.
- You can rearrange the LTC formula to solve for the loan amount. In other words, you can rewrite the loan to cost formula as:
Loan Amount = LTC x Total Project Cost
- Different lenders offer different loan to cost ratios to their borrowers. And, the LTC value can vary for a given project depending upon its nature and unique circumstances. In our example, the hard money lender offers a 60% LTC ratio on a $10 million project. Therefore, the loan amount would be 0.60 x $10M, or $6 million. Note that the actual loan amount can depend on multiple factors, not just LTC.
Understanding Project Costs
The accuracy of the loan to cost formula depends on how well the developer can estimate the construction costs of the project. If the project is a simple acquisition without rehab costs, then the purchase price is a good proxy for the cost. Although, the buyer will have to add other costs, such as legal and accounting, and overhead.
As you can see in Figure 1, the Sources and Uses Statement for a real-world hotel and mixed use development project neatly encapsulates all of the major costs that go into the total project costs. These costs are shown on the right side of the page under Uses. These include:
- Land Costs: The cost of acquiring the land, including closing costs.
- Pre-Construction Costs: Any and all costs expended by the developer and/or contractor prior to closing on the new construction loan. This includes any and all liability insurance.
- Site Work: Before construction can begin, the contractor incurs costs for certain site work. Such costs include demolition, site preparation, and infrastructure work.
- Direct/Hard Construction Costs: These are costs arising from the material and labor that go directly into the construction of the property. The line items refer to types of equipment (i.e., mechanical, electrical, elevators, etc.) and materials (i.e., concrete, metals, masonry, wood, plastics, etc.). Other direct costs include finishes, furnishings and special items.
- Miscellaneous Hard Costs: These includes costs for furniture, fixtures and equipment (FF&E), contractor fees and contingency fees for the contractor and the lender.
- Soft Costs: These costs are indirect costs. Furthermore, they include fees for architecture, engineering, property taxes, local permits and fees, insurance costs, and more.
- Closing Costs: The fees paid at the closing, include loan documentation, title, recording, inspection and project cost review.
Importance of the Loan to Cost Ratio
The LTC ratio helps lenders underwrite real estate construction loans. It does this by setting a limit on the loan amount that directly relates to the cost of the property. For borrowers, knowing the typical LTC for their type of project and lending source helps them establish a budget. This includes the amount of equity the borrower will be required to contribute. The contribution might be all cash, or perhaps a mix of cash and land.
Loan to cost ratios might also affect the interest rate on loans. For example, suppose most hard money lenders are offering a 60% LTC ratio on rehab loans. You might find one offering a higher LTC but at a higher interest rate. The reason for this is risk. The higher the LTC, the more risk the lender assumes. The whole point of LTC in real estate is that the property (or other properties) serves as collateral. Furthermore, a lender needs to easily recoup its loss should the borrower default. Higher LTC ratios create less collateral cushion for the lender. And, therefore the funding source will require a higher interest rate to offset the additional risk.
Pros and Cons of LTC Ratio
Loan to cost remains a very important metric when financing real estate projects, for two important reasons:
- Accuracy: Using LTC requires the actual total project cost, not just an appraisal. Thus, the result is more accurate.
- Reality: The lender makes the loan based on what the borrower realistically expects to spend on the project. The lender will review the contractor’s detailed construction budget. The lender will then compare and contrast the contractor’s detailed construction budget with the lender’s own proposed construction budget.
However, there are two challenges to consider when you use the loan to cost ratio:
- Uncertainty: The total project cost is harder to accurately estimate during the project’s early stages.
- Repairs: The LTC ratio understates the value of the property if you extensively repair or rehabilitate it. A better metric would be the loan to value ratio, which allows borrowers to access more funding using the after-repair value.