CRE terms 13: Lucky no.13
Although we can’t quite believe it, this is now the 13th edition of our commercial real estate (CRE) terms and definitions blog. In this series over the past year, we’ve explored and unpacked many of the common and not-so-common words and phrases associated with this fascinating and dynamic industry. In fact, it is this dynamism (of the field) that means these blogs continue to be some of our top-performing content, read by people around the world – both within the industry and those looking to break in.
For today’s edition, we explore three financing terms: Loan-to-value ratio, property equity, and vendor finance.
Loan-to-Value Ratio (LTV)
Loan-to-value ratio – also commonly written as loan to value (without the hyphenation), or abbreviated to LTV – is used in both residential and commercial property financing, typically as a risk mitigation strategy by lenders. The ever-useful NAIOP Terms and Definitions document defines LTV as follows: “The ratio between a mortgage loan and the value of the property pledged as security, usually expressed as a percentage”.
Without getting too bogged down in the specifics, a ratio is an expression of the relationship between quantities – so LTV is the relationship between what loan is offered by a lender and what the property is valued at. If you got a 110% LTV, you’d have the full value of the property loaned to you, plus ten percent extra for upgrades, for example.
Given this, I also quite like the G-Maven explanation: “Higher LTVs means more risk for the lender. Lower LTVs mean there is lower risk to the lender. I.e. if the borrower cannot meet their financial obligations, and the property has to be sold, there is a higher chance of the property being sold at a value in excess of the property’s debt value. This means that the lender has a greater chance of recovering their loan.”
Related to the above, G-Maven offers this extra tidbit for us: “Out of interest, the property value less the loan value is known as the property equity.”
So if a buyer was offered financing at a 90% LTV, they would typically put in the 10% difference in cash, and their equity in the property would be equal to that amount. It’s what they actually have paid for (as opposed to financed), and – as NAIOP explains – it is what would be sold or liquidated in the event of recapitalization.
Vendor financing is an alternative to traditional financing from a bank or financial institution, and might take the form of debt (a loan) or equity financing. With the latter, you’d offer something like company stock to underpin the transaction or to close the gap between the cash or financing a buyer has and the asking price. Here again, G-Maven’s CRE dictionary has a great example of how this would work practically.
But be warned: Vendor financing has a reputation for being expensive debt. Given that it is often deployed as a means to getting a loan when one doesn’t meet the criteria of more traditional lenders, most providers often “price in” the risk, through higher rates or harsher conditions.