Understanding Loan-to-Cost (LTC) Ratios in Real Estate Financing

What Is the Loan-to-Cost (LTC) Ratio?

The loan-to-cost (LTC) ratio measures the financing given for a commercial real estate project relative to its construction costs. The LTC ratio allows commercial real estate lenders to determine the risk of offering a construction loan. It also allows developers to understand the amount of equity they retain during a construction project.

The LTC ratio is calculated by dividing the loan amount by the construction cost. While the LTC ratio focuses on the costs of construction, the loan-to-value (LTV) ratio compares the total loan amount to the market value after project completion.

How to Calculate the Loan-to-Cost (LTC) Ratio

Calculate the LTC ratio by dividing the loan amount by the construction cost.

$\begin{aligned} &\text{Loan to Cost} = \frac{ \text{Loan Amount} }{ \text{Construction Cost} } \\ \end{aligned}$​Loan to Cost=Construction CostLoan Amount​​

Similar to the LTC ratio, the loan-to-value (LTV) ratio also compares the construction loan amount, but with the fair market value (FMV) of the project after completion.

Understanding What the LTC Ratio Reveals About Project Financing

The LTC ratio shows what percentage of a loan a lender provides based on construction costs. After construction, the project's value changes, so LTC and LTV ratios are both considered in real estate construction.

The LTC ratio helps to delineate the risk or risk level of providing financing for a construction project. Ultimately, a higher LTC ratio means that it is a riskier venture for lenders. Most lenders provide loans that finance only a certain percentage of a project. In general, most lenders finance up to 80% of a project. Some lenders finance a greater percentage, but this typically involves a significantly higher interest rate.

While the LTC ratio is a mitigating factor for lenders that are considering the provision of a loan, they must also consider other factors. Lenders will also take into account not only the location and value of the property on which the project is being built, but also the credibility and experience of the builders as well as the borrowers’ credit record and loan history.

Practical Example of Loan-to-Cost (LTC) Ratio Application

Suppose a commercial project costs $200,000. The lender offers a $160,000 loan to ensure the borrower has equity, encouraging project completion.

The LTC ratio on this project would be calculated as $160,000 ÷ $200,000 = 80%.

Comparing Loan-to-Cost (LTC) and Loan-to-Value (LTV) Ratios

The LTV ratio, similar yet different from the LTC ratio, compares the total loan to the project's value after completion, not its construction cost.

Considering the above example, let us assume that the future value of the project, once completed, is double the hard construction costs, or $400,000. If the total loan given for the project, after completion, is $320,000, then the LTV ratio for this project would also be 80% or $320,000 ÷ $400,000.

The Bottom Line

The Loan-to-Cost (LTC) ratio is a tool for comparing the financing of a commercial real estate project to its construction cost. A higher LTC ratio signals increased risk for lenders. Lenders typically offer financing for projects with an LTC ratio up to 80%, providing a specific benchmark. The LTC ratio is used in tandem with the Loan-to-Value (LTV) ratio for assessing overall risk and financing strategy. It's important to consider additional factors like the builder's credibility and the project's location when evaluating the risk of a construction loan.