Likely the most discussed ratio in real estate lending is the “loan-to-value” (or “LTV”) ratio. Conceptually, it is a fairly simple concept: it is the ratio of a loan to the value of an asset purchased with the proceeds of the loan. Nowhere is it discussed more often than in mortgage investment circles!
One of the big reasons folks invest in or buy mortgages is for the income they generate and the security they provide. An indicia of that security is the how much asset value has been given to secure the repayment of the mortgage loan. “Loan-to-value” has become the common marker for this.
The mortgage investment markets have been inundated with promoters promising investors returns of 8%, 10%, 15% and higher. If an individual is living on a fixed income, these investment returns are very attractive compared to what the individual may be earning on an ordinary GIC (3%), high interest rate savings account with a chartered bank (2%/2.5%) or a Canadian Treasury Bill (1.67% per annum on 3 Month).
The general rule of thumb is the higher the interest rate, the higher is the perceived risk of the mortgage investment. One way of assessing risk is studying the loan-to-value.
There are nine critical factors to entertain when looking at LTV.
1. Understand how to read the ratio!
The ratio is the value of a debt that has been secured against a present value of an asset that has been offered by a borrower as collateral. If in the event the debt has not been repaid, the lender can seize the asset and sell it to satisfy the debt owed. For example, a person buys a house for $100. That is the presumed value of the house. The person has $40 of their money and needs to borrow $60 to complete the purchase. A lender will agree to provide the $60 if the person is willing to put up the full value of the house to secure the repayment of the $60. So the lender in this example is getting $100 worth of property as security for the lender’s $60 loan.
The “loan to value” in this example is $60 of loan to $100 of value or an LTV of 60%. So, theoretically, the lender has $1.66 of security for each $1!
If there is a default in payment, the lender can sell the house to repay itself what it is owed under a “power of sale”. Under a power of sale, the lender is granted a right to evict the homeowner and sell the property. From the proceeds of any sale, the lender is only entitled to what it is owed. Any surplus must be paid over to the homeowner, the title holder. With the cooperation of a defaulting borrower, a well orchestrated power of sale can happen in weeks.
The alternative remedy for a lender is a “foreclosure”. Under a foreclosure, title is vested in the lender by way of a judicial proceeding. Once the lender is vested with title, the lender is free to do with the property what it wishes without any accounting to the borrower. If the lender sells the property and recovers a windfall, the windfall is the lender’s to keep! Foreclosure is time consuming and expensive as it involves lawyers and the courts – it can take anywhere from six months to a year.
2. A ratio is time sensitive
The LTV ratio is determined as at the time the loan is advanced. Therefore it’s fixed for the purpose of the loan! As time passes, the actual value of the securitized asset can go up or down. Once the loan is out the door the value of the lender’s security (i.e., the asset the borrower has offered the lender as “security”) is subject to the whims of the market. The asset may go way up in value and thereby give the lender a “windfall” in terms of additional value against which the lender’s debt is secured or it could go the other way! Regardless of which way the value goes, the lender is owed the same amount!
3. Fixing a “value” can be hard!
The LTV ratio is the loan amount against the value of the asset. What the “value” of the asset is can sometimes be a difficult matter to determine and have parties agree upon! Obviously a borrower will want the asset to have the highest value possible. The lender on the other hand will want a conservative value, a value the lender believes can be easily realizable in the event the lender is forced to sell the asset to pay off the loan. Borrowers will often insist that their property is worth much more than a lender is willing to accept. Lenders complain that borrowers are too greedy and fail to appreciate that the value of their property might not be worth as much as they think if a sale of the property is forced to repay the debt.
This problem is most often satisfied by hiring an independent third party to assess the value of the asset being offered as collateral. An appraiser is selected (ordinarily by the lender) to provide an arm’s length opinion on the value of the asset. As the appraiser is independent of the lender, the borrower will typically agree with the appraiser’s conclusion. Where there is disagreement and the parties are willing to continue to work together, sometimes a second appraisal is obtained and the parties may agree to take an average of the two.
4. Fixing a “value” can be hard!
The interest rate is related to the LTV, but in the broader context of the overall risk of the transaction. Where the LTV is low, it is ordinary to expect a relatively low rate of interest as the average person’s common sense would say, “Hey, the borrower has given a lot of asset value to cover the risk! The lender should really give the borrower a break and reduce the interest rate accordingly!”
“Not so fast” the lender would reply. The first business of the lender is to be repaid – not to enforce security! What a lender charges another for the use of its money reflects an undertaking of the perceived risk. If the borrower is unemployed yet asset rich, for example, the lender will reflect that in the rate it will charge that particular borrower. Though there may be lots of assets to take in the event of default, if there is serious risk the borrower is likely to default, that eventuality will be reflected in the pricing of the loan (i.e., the interest rate!). What might ordinarily be a 6% loan will now be a 12% loan. Further, if the lender is truly concerned about being repaid, the lender may insist that all the interest payments be paid up front to be deducted off the monies being advanced! (The way this works is if the loan is $100 and the rate of interest is 12%, then the lender will advance the borrower only $88, paying itself all the interest on day 1 of the loan!). It is interesting to note that this early payment will result in a slightly higher yield to the lender.
5. LTV Indirectly Reflects Marketability of the Underlying Asset
Another occasion where there appears to be an incongruity between the rate charged and the asset given up as collateral is where there is concern about whether or not the asset can be easily sold to satisfy the debt obligation. It may be wonderful to have a debt security on a property that is 40% LTV, but if you can’t sell the property then it is kind of meaningless.
All lenders price with a mind to realization. Though it may sound depressing, a lender always approaches a transaction with the conservative view that the potential borrower will default. And it is not at all a statement about the borrower; it is simply how a debt transaction is assessed by a lender, any lender.
So, for example, if I lend to someone in a buoyant market like the City of Toronto and they offer me their home as security, I know, as a lender, that I can “realize” (enforce my mortgage) in under 3 months through a power of sale (and if I have a cooperative borrower, we’ll do it in less than six weeks). On the other hand, if the house is a vacation property in Northern Ontario, I might be stuck with it for six months or longer. How easily it is to sell the underlying asset goes directly to the cost of borrowing and will be reflected in the LTV.
6. A High Interest Rate can Mean Anything!
Does the interest rate rise proportionally to the percentage loan to value? No. The rate is generally determined by the market. It will be determined generally by (i) liquidity (see above), (ii) the actual loan to value as discussed, (iii) the desperation of the borrower and how many fingers there are in the LTV pie!.
The general rule of thumb is the higher the interest rate, the higher the risk of the mortgage investment. Many promoters of mortgage investments tout returns of 8% and more. Generally in the Canadian mortgage investment market these would be “second” mortgages or “thirds” meaning that they stand behind a first or second mortgage as the case may be. Knowing the rank of your mortgage before investing is imperative as everyone ahead of you has the right to sell the asset before you to have their own indebtedness paid off before you! When a second or third mortgage is registered against a property, the loan to value compresses for each lender who subsequently registers their interests on title. The result is that there becomes less asset to pay off indebtedness in event a borrower defaults, especially when all the costs of realization come into play.
For example, in regard to the house that costs $100 and you secured financing for $60 of the purchase price, the lender has $1.6 for each $1 the lender advanced. If you need to borrow a further $50 dollars from a different lender, that second lender will say “No way!” as there is simply not enough asset value to cover its proposed lending. The borrower only has $40 of asset value left. A second lender might look at that and say, “OK, I’ll give $30 against the remaining value”. That second lender only has $1.3 for every $1 it advances, assuming of course the first lender’s indebtedness never goes beyond $60. For the additional risk it assumes, the second lender will charge a much higher rate than the first lender because it hasn’t got as much asset value to secure itself.
A high rate of interest will generally signal a high loan to value ratio. As the first lender always gets the first kick at the asset, the second lender will have to wait to see what’s left over to determine if there is enough to satisfy the second lender’s debt obligation. If the asset has gone down in value, the second lender may be in serious trouble if there is an event of default!
A high rate of interest is generally a red flag for a wide variety of things, a high LTV being just one of several risks!
7. Loan to Value is a Strictly Relative Value
What we mean by loan-to-value being strictly a relative value is that LTV is particular to a given market. What is very good LTV in one market may be horrible in the next. A simple example is Toronto. A loan-to-value of 80% for a first mortgage is quite normal. If I was to move beyond Toronto to Guelph, the loan to value for a first mortgage there might be 70% and in Kitchener-Waterloo it might be 75%. The more illiquid the market, the lower loan-to-value a lender will insist upon for advancing funds. In certain rural communities in Northern Ontario a first mortgage might require a loan-to-value of 50%!
8. Loan-to-Value can Change!
The nightmare of many lenders is a sudden change in the underlying value of the properties they have lent against. A loan-to-value calculation in an ordinary real estate transaction is generally done only once at the outset of the transaction. Thoroughness in the calculation of the LTV requires expense (retaining appraisers and other experts) and time that the parties to a transaction only want to incur once. Yet nothing stands still – markets either rise or they fall and they are subject at all times to unexpected events. What one may have thought a very conservative investment may suddenly become a very risky investment given events beyond the lender’s/investor’s control (such as the credit crisis of 2008 or the COVID-19 pandemic of 2020). Values are always changing and with them so are the underlying actual LTV calculations. As the actual LTV ratio changes, so too does the risk profile of the mortgage investment. Lenders constantly monitor their original LTV calculations against actual LTV values as markets undulate forwards and backwards.
9. Get an Expert! Get Fundscraper!
Assessing loan-to-value is not a “one off” pastime. Investing in real estate can be profitable and, for some, even enjoyable! Before making any investment in real estate, whether it be a mortgage opportunity, a participation in a limited partnership or becoming a member of a mortgage syndicate, speak to a qualified advisor registered with the OSC or FSRA who is an expert in mortgages. Loan-to-value might seem like a pretty simple concept to grasp, yet many investors have lost very large sums of money by investing in highly leveraged properties (i.e., high LTVs!). Their money was not stolen; it was simply poorly invested behind money that was smartly invested.
At Fundscraper we review residential and commercial real estate transactions all the time – it’s our “day job”! We work closely with our borrower clients to make sense of the value propositions they advance and do the homework necessary to insure the loan to value we determine based on the evidence in front of us is an accurate and safe assessment against which we are willing to risk our money. At Fundscraper we invite everyone to share in the opportunities that we create with our borrower clients. Join the Fundscraper community and take advantage of the educational resources found there. Learn how mortgages and private real estate investment can be great investments at www.fundscraper.com/signup!