All lenders practically use loan ratios to measure risk and structure their loan programs based on specific metrics known as loan-to-value (LTV), loan-to-cost (LTC) ratios, and loan-to-after-repair-value (LTARV). These ratios are used when lenders underwrite a loan for an acquisition of a property.
When a traditional lender underwrites a loan for an investor to acquire a value-add opportunity, the LTV ratio is used for only the purchase price without considering the renovation budget. These costs will need to be funded by the investor’s equity.
For investors in the residential asset class looking to create and monetize the potential value at the time of acquisition, the underwriting process of a traditional lender may not be the optimal choice. Investors need a lender to recognize the value of the potential and underwrite to it.
A private lender meets this objective.
The deals with a value-add opportunity belong to the type of investments that private lenders seek and shine in. The underwriting of these deals includes another calculation known as the after-repair value (ARV). This is how the underwriting principles of a private lender meet the objectives of a real estate investor.
This article will explain the theory and use of these calculations by private and traditional lenders.
Key Takeaways
- Loan-to-value (LTV) ratio establishes the maximum loan amount offered by a traditional lender when underwriting second mortgages, refinances, or equity lines of credit
- Loan-to-cost (LTC) ratio establishes the maximum loan amount when applied to the purchase price or the construction costs
- After-repair value (ARV) is used by private lenders in their underwriting to monetize the market value of the planned improvements
- Traditional lenders do not use an ARV in their underwriting because no value is given to planned improvements while private lenders do
Before the explanations of the theories and the uses of loan ratios are given, the reader should know that the contents of this article is targeted to the real estate investor in the residential asset class seeking to monetize a value-add opportunity.
The Loan-to-Value Ratio (LTV)
It is safe to say that the LTV ratio is a part of the underwriting criteria of all lenders. What differs between traditional and private lenders is their application of it. At the time of acquisition, the property’s price is considered the value regardless of the seller’s motivations or the market.
The LTV ratio is one of the measurements of risk. The higher the loan when compared to the value, the higher the risk level. As a general rule, an acceptable LTV ratio for banks for an owner-occupied home, without any government guarantees, is 80%. A term sheet could be offered for LTVs greater than 80%, but the rate will be higher and could include the requirement of private mortgage insurance. This requirement will increase the cost of capital.
For investment properties, an acceptable LTV ratio could decrease to 65%. This 65% applies to the purchase price without considering the renovation budget.
Private lenders use the LTV ratio as one component of its underwriting. The theories are the same at the property’s acquisition. The percentage used in this ratio presents the base line of the offered loan. Private lenders’ max LTV ratio typically range from 70% to 90% depending on the borrower’s experience and the scope of the project.
How to Calculate the LTV Ratio
The formula is:
- LTV = Initial loan amount* ÷ property’s as-is appraised value
* Loan amount funded at the origination date to purchase the property. Rehab loan amount is
held back in the escrow and its fund gets released as the renovation project progresses
For an acquisition loan, a bank will usually consider the contract price for the property as the value. There is no consideration for any gaps between the price accepted by a motivated seller and the actual market value. The market value will be used as the denominator when underwriting a loan for refinance, a second mortgage, or an equity credit line.
The Loan-to-Cost Ratio (LTC)
This ratio is used by lenders to calculate the loan amount against the costs incurred thus far. From the view of a traditional lender, the total hard costs in the budget is the value of the improvements.
The term “hard” costs applies to the actual cost of the materials and labor. “Soft” costs, like commissions, permit fees, overhead, and so forth, are not a part of the costs used in the underwriting process and will need to be funded with the borrower’s equity.
It needs to be understood that the LTC ratio used by a traditional lender will only factor in the hard costs of the construction budget of an owner-occupied property. In the deals for investment property, it is not uncommon for the traditional lender to exclude all renovation costs. Therefore, the LTC ratio is not used and the renovation costs are added to the borrower’s equity.
A private lender will use this ratio as another tool to measure risk. The calculation of the LTC ratio will use the total costs expended to date, including soft costs and closing costs like legal and title fees.
How to Calculate the LTC Ratio
The formula is:
- LTC = Initial loan amount ÷ Cost Basis**
** Purchase price, hard and soft costs expended to date, and borrower paid closing costs
It’s important to note that a private lender takes a conservative approach and determines the initial loan amount based on the LOWER of As-is Value and Cost Basis; that is, whichever is lower between LTV and LTC.
A private lender will use the entire renovation budget and the acquisition costs to calculate the LTARV ratio.
The After-Repair Value (ARV)
This calculation is common in real estate investments with a value-add opportunity. This is the third component in the underwriting of a private lender and it serves as an anchor to the total max loan amount (i.e. initial loan + financed rehab loan).
The ARV is a forward calculation of the value to be created at the completion of the renovation scope. Unlike the LTV ratio where the “as is” condition of the property is considered, the ARV uses the projected market value of the improvements as if in place at the loan closing.
The comparisons between the LTC ratio and the ARV are in effect a cost-benefit analysis of the renovation costs against the value of the finished project.
1. The Application of the ARV by Investors
Up to this point, this article focused on the use of loan ratios by a lender to measure risk and to calculate the maximum loan amount. However, an investor with the fix-and-flip objective needs to know its risks and potential profit margin at the time of acquisition.
An important part of an investor’s valuation of an opportunity is to know the parameters of the offer price. A deal will not be successful if the purchase price is too high. This is the aspect of the deal where negotiation is key and the parameters of an offer must be known.
The proper use of ARV will let the investor know the maximum purchase price to offer. As a general rule, the maximum an investor should pay for a value-add property is more or less 70% of the ARV less the renovation costs.
Let’s consider the following as an example of an investor considering an opportunity using the 70% ARV rule:
- ARV = $250,000
- Renovation Budget = $55,000
The formula is:
- (ARV x .7) – renovation budget = maximum purchase price, or
- ($250,000 x .7) – $55,000 = $120,000
Of course, an investor with a high tolerance for risk can go higher than the 70% rule, but there will be less room for a margin of error in the projections for time and increases to the budget.
2. Use of the LTC and ARV By a Private Lender
To bring the theories of the LTC and ARV together, let’s continue with the above example.
- ARV = $250,000
- Renovation Budget = $55,000
- Maximum Purchase Price = $120,000
- Loan Amount = 70% ARV (for Total Loan) and 85% LTC/LTV (for Initial Loan)
- ARV calculation: $250,000 x .7 = $175,000 ⇒ Total Max Loan Amount
- LTC calculation: $120,000 x .85 = $102,000 ⇒ Max Initial Loan Amount
- Total Loan Amount = Initial Loan Amount + Renovation Budget = $157,000
Since Total Loan Amount is less than Total Max Loan Amount, $157,000 will hold where $102,000 will be funded on Day 1 for the acquisition of the property and the renovation budget of $55,000 will be disbursed after a series of project status inspections are performed and the project progress is verified.
As a side note, if the purchase price was $150,000 instead of $120,000, the Initial Loan Amount and thus the Total Loan Amount would have reduced:
- ARV calculation: $250,000 x .7 = $175,000 ⇒ Total Max Loan Amount
- LTC calculation: $150,000 x .85 = $127,500 ⇒ Max Initial Loan Amount
- Total Loan Amount = Initial Loan Amount + Renovation Budget = $182,500
Now, Total Loan Amount is greater than Total Max Loan Amount by $7,500. The excess amount would be deducted from the Maximum Initial Loan Amount, reducing the Initial Loan Amount to $120,000 from $127,500. Therefore, actual Total Loan Amount is:
$175,000 = $120,000 + $55,000
Back to our original example. For the investor’s use, the capital stack for this deal is:
Initial Loan Amount $102,000
Borrower’s Equity 18,000
Purchase Price $120,000
Rehab Budget $55,000
Total Project Costs $175,000
Projected Profit Margin: ($250,000 ÷ $175,000) – 1 = 42.85%
The investor will know that the maximum purchase price to offer for the property is $120,000, and the most equity required at closing is $18,000. A purchase price lower than $120,000 will lower the amount of the required equity. With the profit margin of nearly 43%, there will be ample room for unforeseen surprises such as increased holding costs and a delay in the renovation project.
An investor needs to understand the uses of the loan ratios by traditional and private lenders when considering value-add opportunities. Gone are the days when a lender will lend on the market value of a property at its acquisition.
Also Read; Interest Rates In Private Lending In 2023
An investor also needs to remember that the rates advertised by traditional lenders are for loans targeted for borrowers using the property as their principal residence for the most part. The rates and ratios are very different for investment properties. Traditional lenders will not lend on value-add opportunities with the fix-and-flip objective.
A private lender considers the LTC ratio and the ARV to evaluate risk. The risks in a fix-and-flip deal is the creation of the projected value and the support of the market to achieve the target sale price.
Like the objectives of the investor, a private lender recognizes the potential for value and is willing to invest in its creation. A private lender compares the LTC and the ARV to calculate the maximum loan amount. The investor needs the total costs and the ARV to calculate the maximum offer price.
Same ratios, same theory, but different applications for a successful investment.
