Optimizing Loan-to-Value Ratio in Commercial Real Estate

Commercial investing can be a tricky proposition. When building a portfolio, it's important to strike a balance between the risk you take with a commercial property and its potential return. When financing these investments, banks use a loan-to-value (LTV) ratio to determine if the risk is worth the reward. But what does an LTV mean, and how can you optimize this ratio in your favor?

What is Loan-to-Value?

Loan-to-value (LTV) ratios measure the house's worth versus the requested loan. A house valued at $100,000 with a loan of $80,000 has an 80% LTV. This 80% ratio has long been the standard in residential real estate, allowing buyers to avoid the mortgage insurance premium that a higher LTV would trigger. Generally speaking, the lower the LTV, the better your chance of getting a loan. Interest rates are lower, and buyers are seen as more credit-worthy.

For percentages north of 80, the scenario is much different. Buyers don't have as much cash on the barrelhead and are seen as risky. But an 80% LTV isn't precisely ideal for commercial investors.

LTV in commercial real estate

In commercial real estate, the scenario is a little different. A higher LTV means that an investor can put less money down on a property, which is great for investors looking to quickly flip a commercial investment. 

On the other hand, taking a larger loan on a property means more carrying costs. Investors also risk losing money if the property's value decreases before its sale. Lenders in commercial real estate are also reluctant to lend on a high LTV—they prefer a much lower ratio, around 60 to 70%.

10 Strategies for Optimizing LTV Ratios in Commercial Real Estate

The key is to find the sweet spot between taking on as little debt as possible and keeping plenty of cash on hand for repairs and other expenses. Several strategies can help investors strike that balance between their risk and potential return.

1. Bump up the value of your property

One of the best ways to bolster your LTV is to renovate and improve your purchased property. It doesn't affect your lender's initial LTV but will lead to higher appraisals in the future. This may be useful if you refinance and want to aim for a higher LTV to free up some cash.

2. Get more efficient

If you buy and hold a commercial property then rent it out to tenants, take steps to improve the property's operational efficiency. Add automated management tools and decrease your expenses to improve your net operating income (NOI). This can increase a property's value (and give your LTV ratio a shot in the arm).

3. Finance creatively

If your property requires a high LTV that your lender won't support, consider asking the seller if they will finance a portion of the sale. This increases the LTV but results in less risk for the bank. This strategy can be complicated but may be a good option for new investors who struggle to get financing.

Mezzanine financing is another creative strategy. It allows lenders to convert part of the debt into equity in the company if the buyer defaults. It's traditionally used in acquisitions and buyouts and is also more common in large commercial real estate deals.

4. Negotiate a better deal

You may be used to negotiating lower fees in other areas, but many commercial investors don't realize that lenders are often open to negotiation, too. This is especially true if you have developed a relationship with a lender over the years.

Regardless of your relationship, it never hurts to shop around. Check with multiple lenders to see which offers the most favorable terms. It may not be the bank you've gone with in the past, but take care: your trusted bank may be willing to take a chance on you that others might pass up.

5. Beef up your borrower credit profile

A big part of whether or not a lender offers financing is the borrower's credit profile. New investors may not get funding because they approach the lender like borrowers looking for a residential mortgage. There's much more to a commercial real estate loan.

It's important to come prepared with a strong business plan that lays out a property's potential enhancements and cash flow. Make a compelling case for your investment as a cash cow just waiting to be milked.

You'll also need to improve your personal financial health by paying down debt, improving both personal and business credit scores, and increasing liquidity. These actions demonstrate creditworthiness, even in the face of a higher LTV.

6. Do your homework

Don't use the phrase "due diligence" without doing your homework. Analyze the market you are entering for areas with strong growth potential. This may not be the type of commercial real estate you initially considered, but going against what is most likely to appreciate is a recipe for disaster.

7. Get your timing right

Getting into (and back out of) an investment at the right time is challenging. You'll need to pay close attention to market cycles to determine when your property will likely rise in value (and when it might plummet).

8. Check out government programs

As with Federal Housing Authority (FHA) loans for single-family residential customers, the federal government has multiple programs that accommodate a higher LTV than traditional lenders. The Small Business Administration (SBA) offers Housing and Urban Development (HUD) and FHA loans for some commercial properties, including multifamily properties and apartment buildings.

9. Implement interest rate risk mitigation

Hedge against interest rate increases on variable-rate loans by looking for loans with interest rate swaps or caps. This protects you from sudden dramatic increases in your interest rates.

10. Build up a cash reserve

It can be tempting as a new investor to put all of your cash into acquiring new properties. This is a recipe for disaster, and it may also prevent you from getting a loan with a higher LTV. A cash reserve protects you against loss of income, unexpected dips in cash flow, and emergency expenses that no one can predict. 

Plan to build up a reserve of three to six months of operating expenses, adding to that as you acquire properties. This can take a while to amass, but it's a critical lifeline. Additionally, lenders look at that reserve and may be more inclined to lend to you.

Balancing Your LTV

To optimize the balance of risk and reward, you'll need to consider your investing goals and financial situation. Talking to a financial advisor (or a seasoned investor if you're just getting started) can be helpful. The perfect ratio is different for every investor, but increasing your property's value, decreasing expenses, and getting creative with financing is a more thoughtful approach to getting the LTV that's best for you. 

Get all the data you need to make informed investing decisions with Crexi Intelligence.

Ben Mizes is the Co-Founder and CEO at Clever Real Estate, the nation’s leading real estate education platform for home buyers, sellers, and investors.