A Closer Look at Mortgage Coverage Ratios (LTV, LTC, and LTA)
What is the priority of my mortgage lien?
The first factor to consider before understanding coverage ratios is the priority of the mortgage lien.
Themortgage is a security interest in real property; it is executed by a notary and recorded in the land registry. This entails two significant guarantees:
- In order to sell the mortgaged property, the lender(s) must consent to the sale, with payment to be made directly by the notary;
- In the event of default on the loan, the property may be foreclosed upon. Mortgages may be registered in different ranks, which determine the order of repayment, with the first-ranking mortgage being repaid first, followed by the second- and third-ranking mortgages, if applicable.
It is therefore important to properly factor in the value of priority ranks when calculating coverage ratios.
Let’s use a concrete example to explain this: a real estate investment transaction involving a building that will be resold in four units, each with a value of €250,000. The revenue (the value of the transaction) is therefore €1 million. The property is purchased for €580,000, and the developer spends €170,000 on renovations, resulting in a cost of goods sold of €750,000.
The mortgage may have a different priority depending on the situation:
Example 1:First-lien mortgage for a Raizers loan of €600,000 and an equity contribution of €150,000.
Example 2: A second-lien mortgage for a Raizers loan of €200,000, with a first-lien bank lending €350,000 and an equity contribution of €200,000.
Loan-to-Value, or “LTV”
The LTV is one of the key coverage ratios to consider when evaluating an investment. It represents the value of the loan relative to the future value of the asset. Thus, the lower the ratio, the stronger the security, as this means that the proceeds from the sale will make it easier to repay the debt.
Example 1: The loan is for €600,000, and the expected revenue is €1,000,000.
-> LTV = 600/1,000 = 60%
This means that if the property were sold for more than €600,000, Raizers would be repaid the full amount of the loan.
Example 2: The Raizers subordinated loan is for €200,000, the bank provides a senior loan of €350,000, and revenue is €1,000,000.
-> LTV = (200 + 350) / 1000 = 55%
Contrary to what we might have expected, Example 2 shows a lower LTV because the total debt is lower, as the operator is contributing more equity. There is better coverage.
However, it’s important to keep in mind that being asecond-lien lender means you’ll be repaid after the bank. Thus, in the example given, sales of €350,000 will be required to repay the bank—that is, two lots representing revenue of €500,000. The second-ranking creditor will be repaid from the remainder of the second lot (500–350 = 150).
Loan-to-Cost, or “LTC”
The LTC allows you to compare the loan amount to the total project cost.
Example 1: The loan is for €600,000, and the cost of purchase and renovations (the total cost) is €580,000 + €170,000 = €750,000.
-> LTC = 600/750 = 80%
Example 2: The loan is for €200,000; the bank lends €350,000 for the same cost of €750,000.
-> LTC = (200 + 350) / 750 = 73%
Selling an operation at cost results in a zero margin for the entrepreneur. This ratio therefore shows us our coverage relative to the operation’s break-even point.
Loan-to-Acquisition or “LTA”
The LTA represents the proportion of debt relative to the asset’s purchase price. It differs from the LTV when value is added to the real estate property (renovations, rehabilitation, sale under a tax incentive program, sale in separate units, etc.). It reflects the risk taken at the time of acquisition.
In fact, if the asset improvement projects are not carried out for various reasons, the asset can be valued at its acquisition price, and its resale can therefore be assumed to be for the same amount. Once again, the lower the ratio, the better the collateral. However, it is common for this ratio to exceed 100% when the financing covers both the acquisition and a portion of the improvements.
Example 1: The loan is for €600,000 and the purchase price is €580,000.
-> LTA = 600/580 = 103%
Example 2: The Raizers loan is for €200,000, the bank lends €350,000, and the purchase price is €580,000.
-> LTA = (200 + 350) / 580 = 95%
Here, we can assume that the capital would be preserved even if the contractor did not carry out the planned work.
You now have everything you need to understand these three mortgage coverage ratios, which you'll regularly see in Raizers' transaction details.