As a hard-money lender in Los Angeles, there are many occasions where I have witnessed the terms “loan-to-cost” and “loan-to-value” used interchangeably in conversations and in presentation packages. Through this blog, I want to advise potential borrowers on the difference between these ratios, and the appropriate use of these terms when speaking with, or presenting to, a private-money lender.
I too often hear, “But aren’t they the same?” My short and to-the-point response is, “Not at all. These ratios are very different.” I will explain why.
What Does Loan-to-Cost Mean?
The term “loan-to-cost” is used often in the world of real estate lending and investing. The ratio is the relationship between the costs within the acquisition and renovation budget and the amount a lender is willing to lend.
Let’s be clear—the acquisition cost is the sum of the purchase price and the closing costs associated with the purchase. The purchase price is not a value. Even if a property is purchased well below market, the loan-to-cost ratio is predicated upon the purchase price not the market value. It is the total of the price, the closing costs, and the amount of the renovation scope upon which the loan is based.
A hard-money lender will look to the costs of the project, not the market value of the property or the value to be created by the renovations.
In general, the higher the loan-to-cost ratio, the higher the amount a lender is willing to lend. The other side of this coin is the higher the risk to the lender for which the lender will mitigate by charging a higher interest rate. While still basing the loan amount on cost, a hard-money lender will loan higher into the capital stack than a traditional lender. The basis of this practice is the recognition of the value that will be created at the end of the renovation project. This practice will also mitigate the chance of errors and unexpected costs during the renovation.
The loan-to-cost ratio is used in the initial conversations and presentations to a hard-money lender.
What Does Loan-to-Value Mean?
The denominator of the loan-to-value ratio is the market value of a property, not the cost. This is where an investor takes advantage of the value created by a renovation project.
This is the ratio used at the refinance of a hard-money loan at the end of the project, or for the sale of the property. The loan-to-value ratio is used after the value is created.
The traditional lender looking to place a loan upon a property at stabilization considers a loan amount relative to the value in place and the cash flows generated from the property.
The lower the loan-to-value ratio, the higher the equity in the property.
How Do These Ratios Work in Practice?
I have illustrated below examples of both the loan-to-cost and the loan-to-value ratios for practical application.
Loan-to-Cost Ratio
Let’s say a real estate investor finds a below-market deal on a single-family home. The purchase price of the home is $100,000, and the investor wants to renovate the home at the budget price of $75,000.
The total cost for the ratio is $175,000, the price plus the renovation budget. If the hard-money lender is willing to lend at an 85% ratio, then the loan amount calculates to $148,750.
- $175,000 x .85 = $148,750
The investor will need to invest $26,250 to complete the stack.
- ($175,000 x .85) + $26,250 = $175,000
Loan-to-Value Ratio
At the completion of the renovation, the investor wants to satisfy the hard-money loan through a refinance. The market value of the home is now $300,000, comprising the value of the structure and the value created by the renovations.
If the permanent lender is willing to loan to a 60% loan-to-value ratio, then the loan amount would calculate to $180,000.
- $300,000 (value) x .6 = $180,000
If the investor wants to hold the property to enjoy the cash flow generated from the property, then the investor’s equity in the property would grow to $120,000 without any additional cash outlay.
- $300,000 (value) – $180,000 (loan amount) = $120,000 equity
In addition to the increase in equity, the investor would also realize $30,000 in loan proceeds at the satisfaction of the hard-money loan and paying the closing costs.
- $180,000 (loan amount) – $148,750 (hard-money loan) – $1,250 (costs) = $30,000 proceeds
When are These Ratios Applied?
The loan-to-cost ratio is the calculation that qualifies the investor for a hard-money loan for the acquisition and the renovation of the property.
The loan-to-value ratio is the calculation that qualifies the investor for permanent money after the value is created and the property is stabilized.
It is the loan-to-cost ratio that an investor needs to use to determine the total project budget to not become over-leveraged when the values are considered at stabilization.
If you are an investor looking to acquire and renovate a property and would like more information regarding these ratios, then you need to work with a reputable and respected hard-money lender in Los Angeles. PB Financial Group is a premier, direct hard money and bridge lender who has been providing quick funding since 2006, and who has funded over 2,700 hard-money/private-money loans. Our objective is to satisfy your financing needs on important real estate projects throughout California in an efficient manner.
To learn more about how to successfully finance your next value-add investment, please contact PB Financial Group at 877.700.3707 to schedule a consultation or visit www.CalHardMoney.com to learn more.
