There are a few important phases for any real estate development project that entrepreneurs should be aware of.
The first phase is pre-development where an idea germinates until it becomes feasible. The second is the development phase where the project is built, usually on a construction loan. The third phase, which sometimes overlaps with the second, is the financing phase where the project is secured with some form of debt. One of the key metrics in securing financing is the loan to value ratio.
What Is The Loan to Value Ratio?
This ratio represents the relative size of your loan compared to the relative value of the real estate that you control. This ratio helps the banker to understand how risky the loan itself is. A 100% loan to value ratio represents a project that is financed entirely by debt. A 50% loan to value ratio represents a project that is funded half through debt and half through the owner's equity. Obviously the latter is much less risky for the lender since the owner has a lot of skin in the game.
Commercial vs. Residential
For residential properties, this ratio is quite easy to arrive at. Most homes are not income-producing properties. To get an appraisal, you simply hire an appraiser who makes comparisons to similar homes in the market place and recent sales of similar homes. His valuation then becomes the official value which the bank will use to lend to you. In traditional lending scenarios, before the financial craziness of the early 2000s, an 80% loan to value was sensible. The 20% left became the down payment. If a borrower could not get 20% of the purchase price, then they could get private mortgage insurance (PMI) to help reduce the lender's risk.
Commercial properties also have a loan to value ratio used in lending. The value, however, can be much more difficult to arrive at. Most lenders project out the cash flows for a property (based on signed leases and other expectations) and then discount the cash flows to determine a value for the property. This value is not necessarily in line with the purchase price. For many commercial properties, getting 80% of the appraised value on a discounted cash flow (DCF) basis can cover the entire cost of purchasing the building.
Combined Loan to Value
The analysis above is simple if a project has only one loan on it. Many commercial properties, however, will have multiple loans. In these instances lenders may look at a combined loan to value to assess the riskiness of their position. This analysis includes the position that the lender's debt is in. The first mortgage is in what is called the "senior" position. Second, third, and fourth mortgages then fall in line. The principal is that the first mortgage has the senior position and gets repaid first. If there is a shortage of cash flows to pay debt service, the first loan to get shorted is the one that is last in the pecking order.
For most commercial loans you will be making payments that cover your interest and pay off some principal. In addition, most commercial properties appreciate in value over time as rents go up. Since that is the case, make sure you re-assess your building's value frequently. Be sure to include the equity you have earned as you pay off principal on your loans as you value your property.