'Loan to Cost Ratio' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Loan to Cost Ratio, or LTC, proves to be a measurement utilized by finance companies in extending loans for commercial real estate projects. It is employed ultimately to make comparisons of the offered financing for a given building project versus the expenses of completing said project. With the LTC ratio, lenders of commercial real estate loans are able to decide on the risks involved in backing a particular construction project via loans. The LTC ratio is similar to the LTV loan to value ratio. They both compare the amount of the construction loan to the value in fair market terms of the project in question.
Lenders work with the Loan to Cost Ratio in order to decide what loan percentage or dollar amount the financier is agreeable to finance. They do this with a basis on the firm costs stated in the construction project budget. After construction completes, these projects then possess a new and often times significantly higher value. Future values can often be double what the construction costs prove to be. This means that on a loan for $200,000 in construction, the future value of the project is likely to be $400,000 once it is fully concluded.
Consider how LTC will look in this example. With $200,000 in construction costs, and an 80% LTC ratio, the lender would be willing to loan out $160,000 on the total project. Using a similar 80% LTV ratio metric instead would significantly change the amount of money the lender is wiling to extend to $400,000 x 80% for $320,000.
Lenders never completely finance 100% of construction costs. This is because they feel that the builders also need to have significant exposure to the project in order to guarantee they will give their all to see them succeed. This is what is meant by the colloquial expression “skin in the game.” It prevents a builder from simply getting up and walking away from a project gone bad. It is why the majority of lenders will require a builder to kick in minimally 10% to 20% of the construction costs to secure a financing deal.
Loan to value ratios are not the same as the Loan to Cost Ratio, though they have much in common up to a point. LTV evaluates the loan issued versus the project value once it will be fully completed. Since most banks assume that construction projects will double in value once they are finished, this is why an identical LTV percentage to the LTC ratio will yield twice the loan amount.
Lenders hold firmly to the LTC ratio. It helps them to clearly express the levels of risk in a given financing project for commercial construction. In the end, using a greater Loan to Cost Ratio will entail a significantly riskier project from the lender’s perspective. This is why the overwhelming majority of reputable mainstream lenders will not surpass a pre-determined percentage when they consider any given project. They usually limit this amount strictly to a maximum of 80% of the project’s LTV or LTC. When lenders are willing to become involved at a higher percentage and ratio, they will most always insist on a substantially greater project and loan interest rate to compensate them for the additional level of risk to which they are consenting.
Lenders will also have to consider other information and circumstances beyond simply Loan to Cost Ratio and Loan to value ratios when extending such financing. They take into consideration the value of the property and its location for where the project will be constructed. They also contemplate how much creditworthiness and experience the commercial builders in the application possess. Finally, they consult both the borrowers’ loan payment histories on other loans and their credit record as demonstrated in their company credit report.