The Loan-To-Value Ratio in Commercial Lending Underwriting

In commercial lending the loan-to-the- value ratio is undoubtedly the most important to the underwriter of a commercial loan.  The underwriter of a commercial loan is the person who determines if your loan qualifies or not.

For commercial lending as well as residential lending the formula for the loan-to-value ratio (LTV) is:

LTV ratio = Total Loan Balances (1^st mtg + 2^nd mtg + 3^rd mtg)

                    Fair Market Value of the Property.

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If the commercial borrower is only applying for a first mortgage, and there are no other loans on the property then the numerator of the formula above will only be the balance of the new loan requested.  But, if the borrower is applying for a second mortgage, then the underwriter would include the second mortgage amount in the numerator, and so forth down the line.  The overwhelming majority of the loans we handle do not have a second

mortgage to deal with.  If there is a second mortgage then the LTV ratio is know as the combined loan to value ratio (CLTV ratio).

Now for the denominator….The appraisal generally determines the fair market value of the property, but there is an important exception.  When the proceeds of the mortgage loan are used to buy the same property that is securing the commercial loan, then that mortgage is known as a “purchase money loan.”  If the appraised value is less than that of the purchase price in a “purchase money” transaction, then the commercial lender will use the LOWER of the purchase price or the appraisal.

Commercial lending brokers are often asked by their borrowers to base their loan on the appraised value rather than the purchase price.  The borrower’s claim is usually that they have negotiated a great deal and that the property is worth much more than they are paying for it.  Maybe this is so – but it is generally not true.  Fact is that commercial lenders always base their maximum loan on the lower of the purchase price or the appraised value.  The commercial lender’s argument (it is their money, so there is really not sense in arguing about it) is that an appraisal is really no more than an estimate of fair market value, no matter how fair, competent, conscientious, or trained the appraiser may be.  The only true indicator of value in the marketplace in which a willing buyer and willing seller – each with full and complete knowledge of the essential facts – with neither under any undue pressure, agree upon terms.  If the commercial property in question sells for $523,000 then it’s probably only worth $523,000!  Your commercial lender’s underwriter holds all the cards!

Even though commercial lenders use a number of different ratios when underwriting their loan request, most commercial lending can be boiled down to the results of just

three ratios:  Loan –To-Value (LTV) – Debt Ratio – and Debt Service Coverage Ratio (DSCR).  We will discuss the last two in future articles.