The loan-to-cost (LTC) ratio is an important metric that real estate developers and lenders use to analyze the financial feasibility of a commercial construction project. The LTC ratio is used to compare the loan amount to the total cost of the project, with a higher LTC ratio indicating more risk for the lender. In this way, lenders can use LTC to evaluate the amount of risk posed by a loan—and developers can determine how much equity they’ll have in a project.
What is the Loan-to-Cost Ratio (LTC)?
LTC is a metric that helps lenders understand the amount of risk they will be taking on when lending to a borrower. This is accomplished by comparing the loan amount to the cost of building the project. LTC is usually expressed as a percentage and can range from 0% to 100% or higher—though most lenders won’t lend more than 100%.
A lower LTC ratio means that there is less risk for the lender because the borrower is putting more money down and, therefore, has more skin in the game. A higher LTC ratio means that the borrower is asking for a larger loan amount and therefore there is more risk for the lender.
For a real estate developer, a high loan-to-cost ratio does not necessarily mean that a deal is bad—it just means that there is more risk involved. As long as the investor is aware of the risks and they are comfortable with them, a high loan-to-cost ratio can still be a good deal.
What is a Good Loan-to-Cost Ratio for Developers?
Lenders typically look for an LTC of 80%, but what constitutes a good loan-to-cost ratio for real estate investors depends on the individual circumstances of each deal. However, if the LTC ratio of a project is higher than the 80% threshold, a real estate investor may have a harder time getting approved for a loan.
If the project costs more than expected, a high LTC also may make it difficult to repay the loan. Similarly, if the project is not completed or is not successful, the lender may foreclose on the property and the borrower could lose their investment.
Some investors prefer a lower loan-to-cost ratio because they are less experienced or because they want to minimize their risk. Others may be comfortable with a higher loan-to-cost ratio because they have more experience with flipping properties and are confident in their ability to complete the project within the budget. Even if investors are comfortable with a higher LTC, however, it doesn’t mean the lender will approve the loan.
How to Calculate Loan-to-Cost Ratio
The loan-to-cost ratio of a project is calculated by taking the loan amount and dividing it by the total construction costs.
LTC Ratio = Total Loan Amount / Total Construction Cost
For example, if a borrower is looking to finance a $100,000 project and they have a loan-to-cost ratio of 80%, that means they are asking for a loan amount that is 80% of the total cost of the project. The other 20% would need to be paid out-of-pocket by the borrower or through other sources of financing.
What Does the LTC Ratio Tell Lenders?
The LTC ratio is one way that lenders can assess the amount of risk they are taking on when lending money to a borrower. The higher the LTC ratio, the more exposure the lender has to lose if the borrower defaults on the loan.
The higher the LTC ratio, the higher the risk and interest rate. Most lenders maximize their risk exposure at 80% loan-to-cost. Some lenders will make an exception and provide more than 80% of the construction costs in return for a significantly higher interest rate.
When considering whether to extend financing, lenders look at LTC in conjunction with the investor’s experience with similar projects, market research, the borrower’s credit report, and the potential property value.
Loan-to-Cost Calculation Example
A real estate investment group is looking for a loan for their real estate project that entails hard costs of $1.2 million and is requesting at least 75% of the cost in financing. The lender would then go through the hard costs budget and ensure that the hard costs are all project-related and that they total up to $1.2 million.
If the lender agrees to offer the developer a 75% loan-to-cost ratio, then the loan amount would be $900,000—or 75% of $1.2 million. If the developer covers the remaining costs out of pocket, they retain 25% equity in the project.
LTC vs. LTV
Investors and developers often use the loan-to-cost ratio in conjunction with the loan-to-value ratio (LTV) to get a more well-rounded picture of the financial feasibility of a project. While the LTC ratio looks at the relationship between the loan amount and the total cost of the project, the LTV ratio compares the loan amount to the value of the property.
To calculate the LTV ratio, simply take the loan amount and divide it by the value of the property.
LTC vs. LTV Example
Consider, again, the investor who wants to take out a $900,000 loan to over $1.2 million in construction costs. The loan-to-cost ratio in this instance is 75% ($900,000 / $1,200,000).
If, however, the same property is actually valued at $2 million, the LTV ratio would be just 45% ($900,000 / $2,000,000). In this scenario, the developer retains 65% equity in the development.
