Why LTV Ratios are Important
Trust deed investing in California can be a profitable source of passive income if approached correctly. Trust deed investing can provide higher than average returns, consistent monthly income and the opportunity to utilize private notes to improve your financial position. Although it can provide a consistent cash flow, it can also be risky; this is why it’s crucial for investors to have a full understanding of California markets and the process of trust deed investing in real estate before getting started.
In this article, we will outline one major consideration in determining if an investment is the right opportunity for you. We will define Loan To Value Ratio and take a look at how it impacts trust deed investing.
What is a Loan to Value Ratio?
The Loan to Value Ratio (LTV) is a critical measurement for trust deed investors when underwriting the risk of trust deed investments. There are two positions to consider when calculating LTV: 1st position and 2nd position.
- For 1st position, the LTV ratio is the loan amount as a percentage of the value of the property. For example, if the loan amount is $50,000 and the property value is $100,000, the LTV ratio would be $50,000 / $100,000, or 50%.
- For 2nd position, the LTV ratio is altered – it can be calculated by adding the loan amount to the first mortgage converted into a percentage of the value of the property. If your loan is $100,000, but there is an existing $200,000 first trust deed secured on a property valued at $300,000, your loan to value ratio would be 100% and not 33.33%.
Why is the Loan to Value Ratio Important?
The LTV ratio is one of the most important factors when investing in trust deeds because it measures the amount of equity protecting the investor’s principal investment. Borrowers using hard money to fund a purchase or to refinance cannot typically obtain conventional bank financing due to lack of income, poor credit, or because the real estate asset simply doesn’t qualify. In each of these cases, a trust deed investor can overcome these issues if they are confident that the security of the real estate outweighs the risk. Should the borrower default on the loan and a foreclosure is required, the equity in the property should be sufficient to return the trust deed investor’s principal investment and unpaid interest. That is why a lower LTV (or more equity in the property) means a safer trust deed investment.
What are the Variants of the Loan to Value?
In most cases, the Loan to Value Ratio (LTV) is based upon the current value. A trust deed investment company can underwrite the property to determine its market value, considering there is no value add opportunity. If there are multiple properties to consider, the Combined Loan to Value Ratio (CLTV) is used. To clarify: The CLTV ratio is the sum of the value of all properties securing the loan divided by the loan amount. For example, consider the case of a borrower using two properties, each worth $200,000, to secure a $100,000 loan. The combined value of the two properties is $400,000; therefore, the CLTV would be 25% ($100,000 / $400,000).
The alternative to the traditional LTV is the After Repair Value Ratio (ARV). This ratio is used when the borrower intends to update the property, and the value of the asset is calculated based upon the property’s potential value, or pro-forma. Traditionally, this value has been used for construction loans but is now more popular with rehab projects.
Common Mistakes when Calculating
There are two major mistakes that investors make when calculating the loan to value ratio on a trust deed investment:
- Overestimating the value of the real estate securing the loan – this can lead to lack of borrower equity in the event of a foreclosure.
- Not considering liens that are in superior position – missing this detail can actually result in a zero-equity deal.
How to Get Started with Trust Deed Investing
Trust deed investing is an excellent investment strategy for earning a consistent monthly cash flow. Understanding the collateral value and recognizing your loan position on the property can lead you to long term success. To learn more about investing in trust deeds for cash flow and why trust deed investing appeals to so many investors, please read, Investing in Trust Deeds for Cashflow, or contact us at TaliMar Financial today by calling (858) 613-0111 or visiting talimarfinancial.com.