Loan to Value Ratio (LTV Ratio)
The LTV ratio is calculated as the ratio of the loan amount over the property value or acquisition price, in the case that the loan is used for financing a property purchase. LTV Ratio = Loan Amount / Property Value or Acquisition Price
To demonstrate the calculation of this ratio, consider a loan of $140,000 obtained for the purchase of a $200,000 house. In this case the Loan to Value Ratio is: LTV Ratio = 140,000 / 200,000 = 0.70 =70%
The Loan to Value Ratio is a key indicator for bank loan officers in assessing the risk of a loan. The lower the Loan to Value Ratio the lower the risk of the loan. This is understandable since the property is the means by which the lender will recover the money in case of borrower default. The lower the loan amount compared to the value of the property, the more likely is that the lender will recover the full amount given to the borrower through a quick sale of the property. Combined LTV = Total Loan Amount/Property Value or Acquisition Price
For example, if a property valued at $400,000 has a first mortgage loan with a balance of $250,000 and a second mortgage loan with a balance of $50,000, then the Combined LTV can be calculated as: Combined LTV = (250,000+50,000)/400,000 = 300,000/400,000 = 75%
What is the optimal LTV when financing an investment property acquisition? In order to answer this question we need to answer first whether borrowing will enhance or diminish the return on investor equity. When borrowing has a positive effect on the return on investor equity it is referred to as positive leverage, while when it has a negative effect it is referred to as negative leverage. Note that the effect of borrowing on equity return, or leveraged return, as is commonly referred to in real estate investment terminology, does not depend on the LTV ratio. It is said that borrowing will result in positive leverage when the return of the investment without using borrowing (unleveraged return) is higher than the cost of borrowing or the effective interest rate. Wurtzebach and Miles (1994) suggest the use of the mortgage constant as opposed to the interest rate in assessing whether borrowing will result in positive leverage. If this criterion is used, then the leverage effect of a particular mortgage loan on equity return will not only depend on the interest rate of the loan but also on the term of the loan, which also enters in the mortgage constant formula. In general, if borrowing is expected to have a positive effect on equity return, then the higher the LTV the greater the return on investor equity. The full impact of alternative loan to value ratios on the leveraged return of a particular property investment can be accurately assessed by using the discounted cash flow (DCF) model which takes into account the exact timing and size of expected property cash flows over the holding period of the investment. The impact of a particular loan, which represents a specific Loan to Value Ratio, on the equity return of the investment can be assessed by incorporating in these cash flows the periodic mortgage payments (monthly, quarterly or annual, depending on the time unit in which cash flows refer to in the DCF model) and the payment of the remaining loan balance at the end of the holding period. See more detailed discussion on leveraged IRR calculation. Within this context, when positive leverage can be achieved, borrowing at high LTV ratios is one of the key strategies investors can use to achieve double-digit returns on their equity investments.
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