When purchasing or refinancing a commercial real estate asset, it is crucial to consider how much equity you are putting into the transaction. The general rule of thumb is that the more equity you put in, the better the loan terms you can secure. When considering how much to put down on a commercial real estate loan, you are establishing the transaction’s Loan-to-Value (LTV).
What is Loan-to-Value?
In commercial lending, the amount of equity you put into a transaction is represented in the Loan-to-Value (LTV). The calculation for LTV is:
LTV (acquisitions) = Mortgage Amount / Sales Price
LTV (refinance) = Mortgage Amount / Appraised Property Value
The more equity you put down, the lower the mortgage amount and the lower the LTV. For example, if you are purchasing a multifamily asset for $1,000,000, and plan to pledge $200,000 of your own capital as a down payment, your LTV would be equal to 80%.
An LTV of 80% is on the high-end in commercial real estate – for most programs, an 80% LTV is the maximum. So commercial investors should view the 20% equity as a minimum contribution for most transaction types. In a Freddie Mac Small Balance Loan (SBL) transaction, for example, the maximum LTV for an acquisition in a Top or Standard Market is 80%. For a Small or Very Small Market, the maximum LTV for an acquisition drops to 75% because the lender is taking on more risk with a shorter loan period. If a borrower was looking to obtain a Freddie Mac SBL loan for a $1 million apartment acquisition in a Small or Very Small Market, they would need to put down at least $250,000 to meet the 75% LTV maximum.
In general, you can view the amount of money you are putting into a transaction as a way to lessen the risk a lender is taking with funding the loan. The more risk associated with a transaction, the lower a maximum LTV is going to be.
For example, Hunt has a proprietary bridge loan product for borrowers seeking capital to reposition a non-stabilized asset. That property could be newly built, in-lease up, or in need of a capital infusion for a repositioning. Because these strategies involve a bit more risk than a standard refinance or acquisition of a stabilized asset, the maximum LTV is 75% of stabilized value. That means a bridge borrower needs to put at least 25% down.
More Money Down, Better Pricing
So why contribute more equity and get an LTV below the maximum threshold? The answer is easy – better loan terms. Lenders are willing to reward borrowers contributing more equity with preferred terms or pricing. That’s because the borrower is taking on more risk, or has more ‘skin in the game’. Let’s look at a Freddie Mac SBL rate sheet from January 2019 to see just how your down payment impacts the interest rate.
A borrower putting down 20% (80% LTV) into a 10-year loan in a Top Market was being quoted in the range of 4.97% at the time. A borrower putting down 35% (65% LTV) into the same transaction was being quoted 4.85%. A borrower putting down 45% (55% LTV) was looking at 4.73%. That’s nearly a quarter point difference (24bps), a significant savings in interest paid over the life of a 10-year loan.
When looking for a commercial real estate opportunity, you should initially look for opportunities where you can provide 20% down. If you are able to provide more than 20% down in order to secure preferable loan terms, you need to calculate the amount of savings over the life of the loan and decide if it’s worth parting with your equity up front.