Understanding Loan to Value (LTV) - Part II

Is LTV a good indicator of risk?

In a nutshell

There's no clear line that separates a high-risk investment from a low-risk one, and risk can be a very personal thing based on your financial circumstances, goals and appetite for risk. However, we recommend that investors look at LTVs as an indication of the relative risk, but it doesn't tell the whole story.

If you read our previous piece, Understanding Loan to Value (LTV) - Part I, explaining the importance of changing LTVs in crowdfunding property investment projects, we can see that LTV can be a good indicator of the consequence if something goes wrong with a project, but it is not a measure of the likelihood of the investment failing, for that you need to look elsewhere.

The Loan-to-Value is essentially a marker of the level of protection you have should things not go to plan. It shows what proportion of the value of the security we need secure when the assets are sold in order for you to get your capital back along with the target returns.

It's worth remembering that it is common for there to be additional layers of security in the form of personal guarantees and debentures, although these will not always be in place. These additional layers of protection mean that if the assets have to be sold at auction at lower than expected values, the rest of the money owed can be recovered from the borrowers assets.

It should be noted, however, that for second charge security, investors rank behind the Senior Lender and will not be paid their interest or repaid their capital until the senior loan, interest and fees have been paid in full.

Why an investment with a low LTV is not always a lower risk than one with a higher LTV

This is where the likelihood of things going wrong comes in to play. As a general rule you could say that the more there is to do in a project, the greater the likelihood that something will go wrong.

As such, a bridging loan will usually be less risky than a development loan that has the same LTV. Similarly a refurbishment might be seen as being less risky than a new build project. A development where the exit is via a refinance is generally seen to carry less risk than one where there are multiple units to sell on the open market.

To assess the likelihood of things going wrong you need to broaden your due diligence and consider the risks associated with:

• Planning
• Pre-conditions
• Construction
• Sales
• Refinance

That's not to say that LTV is not important - it is. But it doesn't tell the whole story. It's best referenced when comparing investments within a particular category though, for example amongst loans for single house refurbishments, the one with the lower LTV would be considered better security (if they are in similar locations, with similar demand) than one with a higher LTV. Even then, you should consider what additional security is in place and ensure the investment fits your circumstances and risk appetite.