Number 1: Loan to Value (LTV)
Our top 3 list of most important key performance indicators comes to an end. We already discussed our number 3, the Debt Yield, which measures how much debt service the cash flow can tolerate.
Number 2 was the DSCR, which measures by how much the net operating income (NOI) covers the current debt service.
Now it’s the time to reveal the number 1. I am pretty sure everyone knows this ratio. It is one of the most well-known and discussed ratios, the Loan to Value (LTV). The Loan to Value is an indicator for lenders that measures the riskiness of a transaction.
The LTV is calculated by dividing the loan outstanding by the value of the property.
The ratio is expressed as a percentage such as LTV 80%.
In line with our example from previous posts we start off with an LTV of 80% at the beginning. This tells us that our property has a market value of € 125,000 and we have an outstanding loan of € 100,000. Over time, when our net operating income (NOI) increases, our property gains in value. Thus, in year 5 the property is worth € 135,304 (given a stable multiplier). Now our LTV decreased to 67%. A decrease in the LTV is a positive sign. The de-risking came from two measures. First, the regular repayments led to a decreased outstanding loan principal and second, our increase in rent also led to an increase in property value. Our buffer at the beginning before the loan is at risk was € 25,000. By the end of the financing the buffer increased to € 45,304. This means that the value of the property could drop by € 45,304 before the loan would be in danger.
The LTV is mostly assessed before purchasing a property in order to evaluate how much debt an investor can take on. It is unlikely that private persons will need to recalculate their LTV ratio after that date unless they think of a refinancing or face some troubles with their lender etc. However, this is not the case in the institutional world. Here, LTVs are usually calculated every 2-3 years. Why is this done and how?
The main reason is that a bank is interested in protecting their downside risk. Thus, they are very interested in how much buffer the financing structure has. Buffer, as explained above, is the difference between the market value of the property and the size of the outstanding loan. Because institutional loans are often very large in size (here in Germany up to € 150m approximately) bank are highly interested in having enough comfort to fully regain its outstanding loan.
The monitoring of the loan over time thus includes regular appraisals in order to gauge the current market value. Increases, but especially decreases in market value are important to see preferably as soon as possible. In some structures and when appropriate banks also introduce an LTV covenants. Whenever a certain LTV threshold, e.g. 80% is exceeded, countermeasures can be introduced. Common measures are an unscheduled repayment of loan, a cash trap or a cash sweep.
There is a ton of information out there about the loan to value ratio. What I can usually always recommend are the pages of Investopedia. In this case the site about the Loan to Value.
This concludes our top 3 list of the most important key performance indicators that banks and lenders are looking for in a real estate financing.
Obviously this list is non-exhaustive and there are also many other metrics that are looked at.
It would be interesting to know what you experienced? Are you working for a lender? Which KPI are you looking at the most or at first? Are you an investor? What is your experience with banks?