What is a Loan-To-Cost Ratio?
The loan-to-cost ratio, or LTC, is used in commercial real estate to calculate the percentage that a construction or rehabilitation project's loan amount represents relative to the total project cost. Some examples of costs include purchase price, materials, labor, and insurance costs. Other costs, depending on the scope of the project could include soft costs (like architectural plans and impact fees) or even finance costs like interest and fees.
The formula to calculate LTC is as follows:
LTC = Loan Amount / Cost
As described above, the LTC is calculated by dividing the amount of the loan used to fund the project by the total project cost.
For example, suppose that the commercial property construction total cost is $4 million. Moreover, assume that the lender is willing to lend $3 million. By dividing the amount of the loan by the cost of the project, the LTC ratio is 75%.
A higher LTC results in higher risk for the lender than would a lower LTC. Since lending is risk-based, higher leverage loans call for more conservative pricing and terms. In contrast, commercial property loans with a lower LTC command more competitive structures (i.e. lower rates and more favorable loan terms).
Although the LTC ratio is essential in determining the qualification for a loan, other factors need to be considered. Other factors lenders pay close attention to include but are not limited to: location, borrower financial strength, pro forma income and expenses, and asset class.