The loan-to-cost ratio is defined as the ratio of the construction loan to the total cost of a construction project.
Construction loan ÷ Loan-to-cost ratio = Land Costs + Hard costs + Soft costs + Contingency Reserve
= Construction loan ÷ Total Project Costs
A low-to-cost ratio means that the developer has a lot of his own money into the project. A higher loan-to-cost ratio means that the developer has very little of his own money into the project.
Traditionally, this ratio was not allowed to exceed 80%. However, during the go-go days of the mid-2000’s, this ratio is now allowed to increase to 85% to 90%... and sometimes to 95% to 100% of total project costs! These are wild times!
Many commercial banks still require that their loan-to-cost ratio not exceed 75%, although 80% remains the average.
The cost of a project should always be at least 15% less than the appraised value of the property upon completion, and preferably the total project cost should be 20% to 25% less. This means that the developer stands to earn a profit of at least 15% to 25% of the total cost of the project.
Watch out for deals where the finished value of the project is not significantly higher than its cost. Otherwise, the developer has little incentive to complete the project if costs end up totaling more than originally expected. Otherwise, the developer is likely to say, “Adios!” to the project and to the construction lender halfway through the project.
It is possible to have such a well-conceived construction project that the loan-to-value ratio is only 65% but, because the developer is trying to put very little of his own money into the deal, the loan-to-cost ratio is 95%. In this circumstance,“the book” says the lender should turn the deal down.