Cost gets you in, value gets you out

Lenders express how much they will lend as a ratio, and commercial real estate uses two that sound interchangeable and are not. Loan-to-value measures the loan against the property’s appraised value. Loan-to-cost measures it against what the project actually costs to build or buy. The two diverge most at the riskiest moment in a deal’s life, the handoff from a construction loan to a permanent one, and a borrower who does not see the divergence coming funds it out of pocket.

Loan-to-cost sizes the loan that builds the project. Loan-to-value sizes the loan that has to replace it. When the finished value comes in below cost, the gap is yours to fund.

Two ratios, two different denominators

Loan-to-value, LTV, is the loan divided by the appraised value of the property. A lender offering 65 percent LTV on a building appraised at $10 million will lend $6.5 million. Stabilized, income-producing properties are financed on LTV, because they have a value a lender can appraise.

Loan-to-cost, LTC, is the loan divided by the total cost of the project, land plus hard costs plus soft costs. Construction and heavy value-add deals are financed on LTC, because there is no stabilized value yet, only a budget. A lender offering 70 percent LTC on a $10 million project funds $7 million and requires the borrower to put in the other $3 million as equity.

The appraisal is the number that actually controls

LTV is only as reliable as the appraisal behind it, and the appraisal is the lender’s number, not the borrower’s. It is ordered by the lender, and it can come in below what the borrower expected. When it does, the loan shrinks with it, because the percentage is applied to the appraiser’s value. A borrower who negotiated a $6.5 million loan at 65 percent LTV, then gets an appraisal of $9 million instead of $10 million, is offered $5.85 million. The missing $650,000 becomes equity the borrower has to find, often days before closing. The appraisal coming in low is one of the most common ways a commitment quietly gets smaller between the term sheet and the closing table.

The construction-to-permanent gap

Now put the two ratios together, because a development deal uses both in sequence. The construction loan is sized on cost. The permanent loan that retires it is sized on the completed, stabilized value. The deal assumes the finished value will be high enough that a value-based permanent loan can pay off the cost-based construction loan. When it does not, the borrower funds the shortfall.

Take a project that costs $10 million and is built with a $7 million construction loan at 70 percent LTC, the sponsor funding $3 million of equity. The plan is to stabilize and refinance into a permanent loan at 65 percent LTV. If the finished property appraises at the projected $11 million, the permanent loan is about $7.15 million, enough to retire the construction loan cleanly. If it appraises at $9.5 million instead, the permanent loan is about $6.18 million, and the borrower is roughly $820,000 short of paying off the construction loan. That gap is a fresh equity call, at the end of a project, when the sponsor’s cash is already in the ground.

The consequence: cost gets you in, value gets you out

The two ratios describe two different risks, and a borrower has to underwrite both. LTC governs how much equity you inject to build. LTV governs whether the finished product supports a loan large enough to exit the construction debt. The dangerous assumption is that a project’s cost and its eventual value are the same number. They are set by different forces: cost by the budget and the market for labor and materials, value by the income the finished building produces and the cap rate a future appraiser applies. When those forces move apart, the construction-to-permanent handoff turns into an equity call the original model never showed. Underwrite the exit loan on a conservative value, not the pro forma, and treat the appraisal as a variable that can shrink the loan at the last minute, because it can, and it does.