What is loan-to-cost?

Loan-to-cost (LTC) and loan-to-value (LTV) are two common indicators in the real estate finance world. The two ratios measure the risk of a loan and, to a large extent, are complementary. Now we will see why.

The LTC compares the value of the financing – that is, the loan – to the cost of construction of a real estate project. In other words, the LTC is used to calculate the amount of money a funder-for example, a crowdfunding platform-is willing to lend to a developer relative to the cost of building the project.

LTV is a similar measure. But, instead of comparing loan and cost, it compares the loan to the value of the project once built. As we have seen in another article, loan-to-value is one of the most widely used indicators to measure the risk of, for example, a mortgage loan… or a real estate crowdlending project.

As we know, the risks for the investor in a debt project are essentially twofold:

• Lack of liquidity: when we invest through a real estate crowdfunding platform, there is usually a fixed investment period. During that period, it is not possible to recover the money, so we say that the investment is not liquid. The risk here is that the funds will be needed before the end of the fixed period.
• Default risk: the success of the investment in real estate crowdlending does not depend on the specific success of the financed project. In other words, when lending money, the main thing is to make sure that the borrower will be able to pay us back. As the term is fixed, the aim is that this repayment capacity already exists or is not subject to the completion of the project (for example, to the sale of all the houses).

It may be that the money the developer expects to obtain to repay the loan depends on the success of other projects or the value of certain assets used as collateral. A slowdown in the real estate market or economic uncertainty could affect these other assets and thereby reduce the developer’s ability to repay.

Both loan-to-cost and loan-to-value are primarily related to default risk. A lower LTC indicates that the loan covers a smaller proportion of the total project cost, implying that the borrower has a greater stake in the project and, potentially, a greater financial commitment. If the LTC is higher the developer is more leveraged and the investor stands to lose more money if things go wrong.

Also, a lower LTC provides greater protection for investors in the event of a loan default. If the project is unsuccessful and a foreclosure occurs, investors with a lower LTC have a greater chance of recovering their investment, as the value of the property would cover a greater proportion of the loan.

Although at Urbanitae, seven out of ten projects we finance are equity, we have reasonable experience in crowdlending. We have already financed 26 debt projects, totaling more than €32 million. Of these, more than half have been fully repaid: 15 projects, with a final IRR close to 15%. That is, 12.8 million euros returned to more than 5,200 investors…