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How Loan-to-Value Affects Real Estate Investment Risk

There are many factors that affect real estate investment risk and loan-to-value (LTV) is just one of them, but it’s a very important one. If you take out too much loan relative to the risk, not only will you not see as large a return on your investment as you might have, but you may end up losing your entire investment.

There is a reason successful real estate investors establish loan-to-value criteria for their investments. The loan to value ensures they do not invest more than is necessary to ensure a good return on their investment.

What is Loan-to-Value?

Every property has a value. There is its current value, which is what you might reasonably be able to expect to get for the property if you were to sell it on the open market right now. If the property is in disrepair, that will diminish the value of the property depending on how much investment would be needed to rehabilitate the property so that it can sell at retail. As an investor, the current value of the property is not as important as the future retail value of the property.

For instance, if you are evaluating a single-family home that needs substantial repair, you could be looking at investing $25,000 in rehabilitation alone. If you run comps on like properties within a reasonable radius, you’ll discover that recent properties of similar size and amenities might have sold for $150,000. Subtract the estimated rehab costs and you have a retail value of $125,000.

If you borrow $125,000 to buy that property and repair it for resale, you won’t be giving yourself enough room for profit. Contingencies might take your repair costs to $30,000, in which case, you could lose money on the deal. To prevent that from happening, you need to establish an LTV threshold for your investments.

What Makes a Good LTV Threshold on Real Estate Investments?

Every real estate investor, and every loan underwriter, has their maximum LTV, that threshold over which they will not lend or invest in a property. Whether that investment is for a fix-and-flip property or a buy-and-hold property, you need a maximum LTV threshold in order to protect your investments.

Generally speaking, the lower the end of the market you are operating in, the lower you want your threshold to be. For instance, if you rehab properties that retail for $50,000 and you set your LTV at 90%, that means you are borrowing $45,000 and can only expect a $5,000 return—but that’s if everything goes well. In luxury markets, repairs might cost more, but the cushion for a 10% profit is much larger for a $500,000 luxury home than the cushion for a 10% profit on less expensive properties.

If you set your LTV at 70%, you’ll want to borrow no more than 70% of the property’s retail value. The retail value is the value of the property after repairs. For instance, an investment property that could retail at $100,000 after repairs would yield a $70,000 LTV. That’s the maximum amount you want to borrow to buy that property and make the necessary repairs.

Why a High Loan-to-Value Increases Your Personal Risk

Your investment risk is relative to your loan-to-value. For instance, if you set your LTV at 90%, then you are leaving yourself a 10% cushion for contingencies. That means your investment must be completed without a hitch in order for you to see the 10% profit that you expect. One mishap or unplanned expense could mean the difference between a small ROI and a loss.

For that reason, you’ll seldom see an LTV of more than 80%. You’ll often see them set at 65%, especially in lower-end markets where entire neighborhoods are in disrepair. Buy-and-hold properties often have higher LTVs due to expected property value increases and fewer rehabilitation needs.

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When you borrow money for a property investment, your lender will have their own LTV based on their underwriting philosophy. As an investor, you should set your own LTV and not invest more than you can afford to lose. After all, the LTV is a measure of the risk you are willing to take on that investment.

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