Understanding Loan to Value or LTV is critical to understanding how hard money loans work. On the surface, it’s a simple concept: The loan amount is based on a percentage of the value of the property in order to control the risk of the lender. But viewing LTV from a strictly hard money perspective is a little more complex and requires you to step into the shoes of a hard money lender.
Most loan amounts in hard money lending are determined by the value of the property (or sometimes cost, but more on that later). This makes sense because the property is primarily what is being used to secure the loan. Hard money lenders usually will lend a maximum of a certain percentage of the property value, usually between 65-75%. Little City Investments lends at 70% LTV. This keeps us safe if the borrower defaults on the loan. If worst comes to worst we can always foreclose on the property and safely recoup the loan amount for the investor. This 70% loan to value also protects the borrower, not allowing them to over-leverage the property, potentially getting them into a situation where the property is worth less than the financing.
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Loan to Value for Rehabs
At LCI, we can also base the total loan amount on after-repaired value or ARV. This applies to rehabs (and sometimes new construction.) This method essentially makes us value the property twice: once for as-is value and once for final ARV. While we lend up to 70% of the ARV, we only release up to 70% of the as-is value upfront, then we escrow the remaining funds to be released in draws throughout the project.
Why do we do it this way? To manage our risk. We seek to never be above our risk threshold of 70% at any given time in the loan. But as the borrower adds value to the property, we can safely release some funds and still stay at 70% loan to value. We can continue to do this over the course of a rehab or new construction and ultimately fund the entire project. Check out some of our hard money loan case studies.
But what determines the value of a property for a hard money lender is different than that of a home buyer or even a licensed appraiser. At LCI we perform highly specific, comparable sales research and conduct thorough on-site inspections to value a property. We also leverage our unique knowledge of the local market, development potential and project feasibility to come to our values. But we aren’t looking for exactly the same things as a home buyer or appraiser. We’re laser-focused on liquidation value. This is the LTV of a hard money lender: At what price will a property sell for in less than 30 days?
Liquidation value requires a further fine-tuning of the valuation of a property. Factors in the liquidation value include active days on market (ADOM) for comps, how homogenous the area is, and unique factors such as floor plans and finishes. This process of determining liquidation value can diverge somewhat from a typical appraisal, so often hard money valuations can be more pessimistic than expected.
Why do we care so much about liquidation value? It goes back to security. If the borrower defaults, we must recoup invested funds immediately, and we can’t let a property sit on the market for months on end to sell. We need to be sure that it will sell for at least the loan amount at, or before, the foreclosure auction.
LTV vs LTC
If you’ve been around the hard money world long enough you’ve also heard of LTC or “loan to cost.” This is a different methodology in which the loan amount is determined by the cost of property or the project. The thinking here is that as a lender, you decrease your risk by making the borrower come 30% out of pocket (if lending at 70% LTC) therefore forcing them to have substantial “skin in the game.” As a lender, you also assume that the borrower is generally paying market value for the property and/or paying an average cost for any improvements they are making.
At Little City we do not base our loans on LTC for several reasons. First off, when a property sells, it’s always based on the value placed on it by the buyer. It doesn’t necessarily matter how much the seller spent on it when they purchased it or when they rehabbed it. There is not a 1:1 relationship between cost and value, and value is what matters in the end. Second, LTC can penalize borrowers who are getting a really good deal. If a borrower is purchasing a property at 70% of market value, why should they have to come out of pocket to close a deal that’s already safe? Conversely, if a borrower is substantially overpaying for a property or spending too much on a rehab that the local market won’t support, basing a loan amount on LTC will result in too much exposure and risk.
Little City Investments always makes sure our investors’ money is safe and allocated to loans based on a 30-day liquidation value, not cost. Learn more about investing with Little City Investments.