Understanding LTV and ARV as It Relates to Real Estate Investing
Real estate investing can be a lucrative endeavor, but it's not without risks. When a real estate investor borrows money to purchase property, both the investor and the lender assume some risk.
Understanding the risks and potential rewards can be the difference between smart investing and losing your shirt. Lenders rely heavily on risk assessment when deciding whether to lend you money for your project.
LTV and ARV are factors used to determine risk. Understanding their role in real estate investing can help you navigate the real estate lending process. Here's a closer look at each.
Investing in Real Estate
Real estate investing comes in many forms, as do the investors themselves. A real estate investor is anyone who buys real estate with the intent of making a profit. There are two primary types of investors: individual investors and real estate investment trusts.
A real estate investment trust is a company that owns or finances income-producing real estate. Their investments can include a range of property types like apartment buildings, commercial properties, hospitals, high-rise office towers, and more.
A real estate investment trust is usually a publicly traded company. It's a type of real estate investing that allows investors to buy shares in the company instead of buying real estate directly.
There are a lot of different ways to invest in the real estate market. Some of the most popular real estate investing models include:
- Buying rental properties with the intention of collecting rent
- Buying vacation properties (short-term rentals)
- Buying affordable properties to fix up and sell quickly (flip)
- Buying shares in a real estate investment trust
- Lend money to a real estate investor
There are three types of real estate market:
- The buyers' market,
- The sellers' market,
- And the balanced market.
The real estate market you're investing in will affect the availability of affordable property and how much competition you face.
In a buyers' market, the inventory of available properties is greater than the number of people actively looking to buy property. That generally means properties take longer to sell. It also means the buyer has more latitude to negotiate price and other considerations.
In a seller's market, the number of people who want to buy property is greater than the number of properties available. This excess of demand means buyers have more competition. Properties sell faster, and buyers have more difficulty negotiating prices.
The more lopsided the real estate market is, the greater the effects. There are also balanced markets when the number of available properties matches pace with demand. These are short-lived and often happen when the real estate market is sliding from one extreme to the other.
No matter which real estate market you are in, understanding how to calculate risk in real estate investing can help steer you to smart investing.
How LTV Works in Real Estate Investing
The loan to value ratio (LTV) compares the price of the property and the amount of the loan the real estate investor used to buy it. It's a simple formula: loan amount divided by the purchase price.
If a real estate investor purchases an apartment building for $950,000 with a 20% down payment, the loan amount would be $760,000. So, LTV is 80%.
760,000 ÷ 950,000 = 0.80 or 80%
If the real estate investor borrows additional funds to make some repairs or spruce up the property, say $80,000, the LTV changes accordingly.
(760,000 + 80,000) ÷ 950,000 = 88%
LTV is one of the factors used to evaluate the risk associated with a particular loan. The lower the LTV, the lower the risk to the lender.
A lower LTV is created when the real estate investor pays a larger portion of the cost out of their own pocket. That can create instant equity. It also makes the borrower take on a larger share of the risk of real estate investing.
What Is ARV and How Is It Used?
ARV is the “After Repair Value” of the property. This is what the house should be worth after needed repairs and renovations. Determining ARV requires looking at the sale prices of similar properties sold in the same neighborhood over the past six months.
The property's AVR helps investors set limits on what they can safely spend on a property. The idea is to mitigate risk while ensuring the project is profitable.
Real estate investors who specialize in fixing up homes for quick resale (house flippers) generally follow the 70% rule. This is a simple formula to calculate the property's loan-to-cost ratio (LTC).
Knowing the LTC helps determine the maximum price the investor should pay for a property. The goal is to mitigate risk and ensure the project will be profitable.
It goes like this: the investor should pay no more than 70% of the AVR minus the cost of renovations. So, the formula is (AVR x 0.70) – cost of renovations = maximum purchase price.
If a property's AVR is $200,000, and the anticipated cost of renovations is $40,000, the most the real estate investor should pay is $100,000.
(200,000 x 0.70) – 40,000 = 100,000
The 70% rule is also used by lenders to help determine the maximum loan amount and the down payment they require from the investor. It's especially useful for “hard money” loans or bridge loans because the loan is based on the asset's value and not just your creditworthiness.
Loans Based on LTV vs. AVR
LTV and AVR can affect the way you approach financing. Lenders often have different risk thresholds for each figure. Most traditional real estate lenders, like home mortgage lenders, use an LTV ratio.
Since LTV relies on the property's current appraised value, it's less risky to the lender. So, lenders often require a smaller cash outlay or down payment from the buyer.
Unlike LTVs, AVRs are based largely on what the property is expected to be worth after renovations. It also speculates that real estate values will remain stable or increase by the time renovations are complete.
Since these values are educated guesses, lenders issuing AVR-based loans assume more risk. So, they often require real estate investors to spend more of their own money, including making larger down payments.
Finding the Best Financing Option
There are different ways to finance a real estate investment. The two most popular, traditional bank mortgages and private loans, each have pros and cons.
Bank loans are often cheaper but also harder to get. Private loans can be more expensive, but they’re faster and more flexible.
For real estate investing, private loans are often a great fit. At Gokapital, we specialize in private funding solutions for real estate investors across the US.
Whether you’re a seasoned investor or just getting started, we have loan programs tailored to fit your needs. Apply today to get your next project started.