LTC or ‘Loan to Cost’ ratio is a metric that hard money and traditional lenders use to assess the risk of a loan.
That risk level equates to the chances of a loan defaulting.
When a flipper, developer or any kind of property entrepreneur applies for a loan, the lender will calculate the Loan to Cost ratio.
Lenders use the LTC in tandem with the LTV ratio (Loan to Value) to help them determine:
- a borrower’s eligibility for a loan
- capacity to repay the loan
- interest rates the loan will attract
- the maximum amount they are prepared to lend
Here’s how to calculate the LTC, how to use it and why it is so important.
Calculating the LTC (Loan to Cost)
The formula for calculating the LTC of a property is simple division.
LTC = Loan amount / Total project cost
The loan amount is the total amount of money provided by the lender.
The total project cost includes everything from land acquisition, construction costs, renovations, permits, fees and any other soft costs associated with the redevelopment.
Let’s take a look at a couple of examples.
Example A
Imagine Aaron wants to buy a property for $500,000.
He has a redevelopment budget of $500,000 making the total cost of the project $1,000,000.
He has a downpayment of $100,000 and hence needs a loan of $900,000 to facilitate his project.
The LTC is therefore calculated as $900,000 / $1,000,000 which equals 90%.
Example B
Alternatively, Emma wants to purchase a property for $800,000 and her redevelopment budget is $700,000.
But Emma has a downpayment is $300,000 meaning she requires a loan of $1,200,000.
Emma’s LTC is $1,200,000 / $1,500,000 which equals 80%.
Even though Emma intends to borrow an additional $300,000 more than Aaron, lenders will view Emma’s project as less risky because of her lower LTC.
Emma has more skin in the game!
With less initial capital invested, there is a greater likelihood Aaron could abandon his project if he runs into difficulties.
This puts the loan at a higher risk and leaves the lender vulnerable to being unable to recover their investment.
That’s why lenders favor lower LTCs.
The significance of LTC for developers and flippers
While the LTC is an key metric for lenders, it is important its implications are fully understood by developers and flippers.
Here’s how it impacts them:
Equity proportion – The higher the LTC, the less equity the flipper has in the project and the more they need to borrow.
Risk assessment – A higher LTC indicates a riskier project for the lender. This may see them impose more stringent conditions and higher interest rates on the borrower to protect their investment.
Project feasibility – Flippers with limited cash reserves rely on a favourable LTC to undertake their project. If the LTC is too low, it might push the equity needed to begin some projects beyond their means.
Leverage and returns – A higher LTC indicates flippers are borrowing more money. While this potentially increases the returns on their invested equity, it also requires managing higher debt levels and the associated interest costs.
Market conditions – When markets are booming, lenders may be prepared to lend money with higher LTCs to attract borrowers. But they are likely to be far more conservative in challenging economic climates.
Equity options – Hard money lenders are more likely to make funds available with higher LTCs than traditional lenders.
What is a good LTC ratio?
Most hard money lenders will have an LTC requirement of somewhere between 80% and 90%.
It means borrowers have to start their project with a downpayment of between 10% and 20%.
If the LTC is too high to satisfy the lender, the borrower may need to increase the size of their downpayment to reduce the loan amount.
This can sometimes be achieved by seeking a secondary financing option or joint investment.
LTC vs LTV
When considering the merits of a loan, lenders will also assess the LTV (Loan to Value).
The formula for calculating the LTV is:
LTV = Loan amount / Project’s total value after completion
Lenders’ requirements for the LTV ratio are typically lower than the LTC and are normally in the range of 70% to 80%.
But it is important to appreciate that both ratios are used when lenders consider loan applications and determine loan conditions.
The LTC ratio is the more important metric for house flips, new developments and commercial real estate with high upfront costs.
The LTV ratio is given greater weight for more stable assets such as rental properties.
Get advice today
The LTC or Loan to Cost is a critical ratio for every property developer or flipper because it measures the amount of equity borrowed in their redevelopment.
The balance is the stake or equity the flipper has in their project.
Understanding the LTC of a project allows flippers to make better decisions in terms of structuring deals, minimizing risks and optimizing returns.
In California, equity and Equidy go hand in hand.
Equidy is a hard money lender with one of the most trusted, respected and enviable reputations on the west coast.
We lend money to their valued clients for projects with LTC and LTV ratios that see traditional lenders shut up shop.
We never waver from their core belief that anything is possible and they are determined to prove it every single day.
Even in challenging economic times, we strive to reward entrepreneurship and always help our clients crystallize their wealth creation dreams.
But Equidy is much more than just a financier.
Equidy has an intimate and personal history with property, and has covered all aspects of real estate and property development in California for more than 40 years.
No-one knows more about property development in the golden state.
We have a deep-seated knowledge of the industry, working closely and creatively with our clients, providing our wealth of knowledge and support network as their projects take shape.
Equidy enjoys long and established relationships with serious investors, sellers and real estate professionals while leveraging our reputation and trust, using clear communication to minimise the risk to all parties.
Contact Equidy today to book your free strategy call.