Loan-to-cost (LTC) is a common metric in commercial real estate. Lenders use the loan-to-cost ratio to evaluate how much debt they will lend on a value-add or construction real estate project relative to its total cost. Itâs one of the main metrics CRE lenders use to determine how much risk they will take on for a given CRE project.
Read on to find out how to calculate LTC, examples of how this metric is used in commercial real estate investments and the difference between LTC and loan-to-value (LTV).
Loan to cost ratio, also known as LTC, is an important concept in commercial real estate investing and development. But what exactly does loan to cost mean and why does it matter? In this in-depth guide, we’ll break down everything you need to know about LTC, from the definition and calculation to how investors and lenders utilize this key metric when analyzing potential deals.
What is Loan to Cost Ratio?
Loan to cost ratio compares the amount of financing obtained for a commercial real estate project to the total cost of developing that project. It is calculated by dividing the size of the loan by the total project cost.
Loan to Cost Ratio = Loan Amount / Total Project Cost
LTC allows lenders to assess the riskiness of providing construction financing for a project, It also helps real estate investors determine how much equity they will need to contribute
A higher LTC ratio indicates greater risk for the lender, as the borrower is contributing less equity Most lenders will finance up to 80% of a project based on LTC
Calculating Total Project Cost
When analyzing a potential deal, the total project cost includes both hard and soft costs.
Hard costs refer to quantifiable construction expenses, including:
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Materials
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Labor
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Site work
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Utilities
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Landscaping
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Parking facilities
Soft costs are other necessary expenses not directly tied to construction:
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Design fees
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Permitting
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Legal and accounting
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Insurance
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Project management
Additionally, the purchase price of the land or existing property should be included in the total project cost basis.
LTC vs. LTV – What’s the Difference?
Loan to value ratio (LTV) is related to LTC, but has a key difference.
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LTC compares loan amount to total project cost
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LTV compares loan amount to appraised property value after completion
LTC is more commonly used for ground-up construction or major renovation deals. It accounts for the significant upfront investment required.
LTV is more applicable for deals involving stabilized assets, where purchase price better reflects true value. Renovations are assumed to be minor.
How Lenders Use LTC Ratio
For lenders, LTC ratio is a critical risk management metric. It provides a clear picture of the borrower’s skin in the game.
Most lenders will not finance over 80% LTC, even for strong sponsors. This ensures the borrower has a reasonable equity stake.
A lower LTC requirement gives the lender more cushion. If the market shifts or project stalls, they are better protected.
Lenders may approve higher LTC ratios for top sponsors with a strong track record. However, the interest rate will likely be much higher to offset the risk.
LTC Ratio Requirements Vary by Lender Profile
Maximum allowable LTC can range from 70% to 90% based on the lender’s risk appetite:
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Conservative Lenders cater to institutions like pension funds or insurance companies. They stick to 70-75% LTC to minimize risk.
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Middle-Market Lenders like regional banks are comfortable with 80-85% LTC when working with known entities.
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Aggressive Lenders are private debt funds comfortable stretching to 90%+ LTC for premier sponsors. However, they charge much higher rates.
The market cycle also impacts LTC requirements. Standards tighten considerably during downturns.
How Investors Use LTC to Size Equity Checks
For real estate investors, LTC ratio helps size their required equity contribution.
For example, an investor plans to build a $10 million project. The lender approves 80% LTC financing.
- $10 million total project cost
- 80% LTC = $8 million loan
- $10 million x 20% equity = $2 million equity check
Running these numbers early in underwriting helps investors determine if a deal is feasible based on their available capital. It also informs negotiations with lending partners.
Conservative investors may choose to fund higher equity levels to reduce risk. More aggressive investors may push lenders on accepting higher LTC ratios.
Scenarios Where LTC Ratios Go Out the Window
While most deals fall within typical LTC parameters, certain situations call for exceptions:
Low Cost Basis Deals – If an investor owns land with big appreciation potential, a lender may accept over 90% LTC. Their loan basis is still conservative relative to after-completion value.
Single Tenant Properties – Credit tenants with long-term leases allow lenders to stretch LTC, as cashflow is highly reliable.
Big Name Sponsors – Well-capitalized groups like Blackstone or Related may negotiate up to 100% LTC for trophy assets in prime markets.
Construction Loans – These short-term loans often approve interest reserves that raise the total loan beyond typical LTC limits.
Supply-Demand Imbalances – In overheated markets, lenders compete aggressively and may exceed prudent LTC standards. The same happens in niche sectors with limited financing options.
Key Takeaways on Loan to Cost Ratio
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Loan to cost ratio is a crucial risk assessment metric for lenders and investors in commercial real estate deals.
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LTC compares the loan amount to the project’s total cost, including hard construction costs, soft costs, and land acquisition.
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Most lenders will not finance over 80% LTC, so investors know their minimum equity requirement.
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Loan to value ratio is similar, but compares loan amount to completed property value rather than cost.
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Higher LTC ratios indicate greater risk but may make sense in certain situations.
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When Is LTC Used?
The loan-to-cost ratio is used when you are adding value to a property. This value includes new constructions, rehabilitation projects, flips, renovations, ground-up constructions and bridge loans. Basically, lenders will use LTC for any situation where a property has not yet reached its full income potential.
Example of LTC Ratio in Commercial Real Estate
To explain the concept of LTC, Wilmot shared an example.
Say you want to buy a piece of land for a million dollars to build an apartment complex on that land. The land and construction would cost you $3 million. The entire renovation, with furniture and plumbing etc., costs another $2 million. That adds up to a $5 million deal, but thereâs no value to the property yet.
LTC means a lender is basing a loan amount on the total cost of the project, which in this case is $5 million, and its potential value, rather than the current stabilized value, which is $0. When calculating LTC, the total cost includes hard costs and soft acquisition costs. Essentially, youâre going to include anything that is related to the cost of the project.
Loan-to-cost is expressed in a percentage. The formula to calculate loan-to-cost is:
LTC = loan amount / total construction cost (x100)
Hereâs how the formula would look for the example above if this borrower received a $3 million loan:
70% LTC = $3.5 million / $5 million (total cost of construction) (x100)
Determining the loan-to-cost ratio is a matter of understanding how much the total project will cost and how much debt you are seeking to borrow for the project. LTC typically ranges from 65% to 75% and up to 85% or 90% in some cases. The higher the LTC, the more risk the lender is taking.
There are many factors that will determine the LTC, including the profile of the deal, the asset class, the exit strategy, the real estate market, and whether the loan is recourse or nonrecourse, Matt Rubin, Associate at Lev, told lev.co.
What Is Loan To Cost or LTC?
FAQ
What is an example of a loan to cost?
What does 80% loan to cost mean?
How to calculate loan to cost ratio?
Does a loan to cost include land?
What does loan to cost mean?
Understanding loan to cost meaning is quite important to investors. This ratio is a valuable metric used in commercial real estate construction (and other areas) to determine whether a transaction may be profitable or beneficial to that investor. It compares the cost of financing a project (usually as a loan) to the cost of building the project.
What is a loan to cost ratio?
Remember, the loan to cost ratio is a measure of the amount of financing relative to the total project costs. A higher LTC means there is more debt financing relative to the total cost of the project. When you’re considering a fix and flip property, it’s important to think about the loan to cost ratio.
What is a loan-to-cost ratio?
The loan-to-cost (LTC) ratio is a metric used in commercial real estate construction to compare the financing of a project (as offered by a loan) with the cost of building the project. The LTC ratio allows commercial real estate lenders to determine the risk of offering a construction loan.
What does a higher loan to cost ratio mean?
If the loan to cost ratio is higher, that means the lender is taking on a higher risk transaction. The more the investor puts into the project on their own, the less likely the investor is to walk away from the project, reducing the lender’s risk. Some lenders allow for a higher loan to cost ratio. This could be 80% or higher.