What is Loan to Value Ratio?
Loan to value ratio measures how much debt is borrowed against the value of the asset. For example if the value of the real estate is $1 million is financed with $800,000 of debt then the LVR ratio is 80%.
When looking at real estate investments the overall loan to value of the portfolio can be useful tool in measuring the riskiness of an investment. The greater amount of debt is used means that investors should demand a higher risk. Listed REITs typically utilize 40% to 50% loan to book asset value. While private equity uses up to 75% of debt finance in acquisitions through the use of mezz loans.
Debt Service Coverage Ratio (DSCR)
Another important metric which measures the level of indebtedness is the debt service interest coverage ratio. The debt service coverage ratio shows how much of the current asset income covers total interest paid against the borrowing. This is less important in the lower interest environment but it is important to keep an eye on as rates normalize.
Loan to Value Ratio and Equity Sensitivity
There is more of a inherent risk in investing with high leverage on listed investment which are exposed to market volatility does not have the same luxury since asset values changes on a daily basis.
For direct real estate investments the value of the asset is rarely marked to market which means investors are more comfortable in using higher ratio in the process.
Debt however can be a double edged sword, it can magnify returns as well as increase the risk of the investment and can be your friend in up markets but your worst enemy when real estate prices are falling.
Investors need to understand the sensitivity the level of debt can magnify movements in asset prices on investor equity.
From downside protection perspective the higher level of debt means that the lower amount of asset value has to move to wipe out the equity in the investment.
The chart shows the percentage fall required in the asset value before equity is wiped out.
At 95%, the asset only has to fall 5.26% to reduce investor equity to zero. If 70% of the asset value is debt financed, the asset has to fall 42.86% before reducing total equity to zero. Sometimes lenders will require additional collateral will be required before zero.
How to Maximize Borrowing Capacity
For those that are looking to leverage up and maximize returns. Lenders use the following criteria when deciding how much the investor can borrow. The below are examples are for those that want to borrow without the backing of deal by deal or asset finance facilities usually used in private real estate funds.
- borrower income – income plays the largest factor in determining total borrowing limit. High income plays a factor but also the breakdown of income from salary and other investment income. Depending on the bank some would put more weight and reliance on salary than dividend or capital gains.
- Living expenses – each bank would have its own benchmark in living expenses for singles and couples so there is a lower limit on expenses that the bank would use in determining borrowing capacity.
- Other credit loans- these include other personal loans, margin loans, credit cards or unsecured loans
- Assets – depending on the asset. The most standard asset, the ease more lenders will be willing to lend against it. Usually it is not an issue for houses but some lenders do not like tiny apartments smaller than 300 sq ft on top of everything else. Buying these kind of asset would limit the potential lender pool.
- Other asset – if the individual has other assets this would be a factor. For those that are borrowing for investment should also be aware of the risk in cross collateralization of loans.
How to Use Debt in Real Estate Investing
Our approach is to use leverage dynamically in real estate investing where we do not have a target loan to value ratio. Instead we are conscious of the total debt in the portfolio and the leverage is depending on opportunities irrespective of market conditions.
As market value of the portfolio increases it does not mean automatically we will regear. We will keep our powder dry and redeploy once the new opportunities are identified and happy to take counter cyclical positions.