Okay, we're halfway done discussing the loan-to-cost ratio in commercial mortgage finance. So far we've discussed how to compute the total cost of a commercial project. We have also discussed the loan-to-cost ratio in new, from-the-ground-up, commercial construction loan underwriting.
Today we're going to talk about the use of the loan-to-cost ratio while underwriting renovation commercial loans and fix-and-flip commercial loans.
By the way, if you happened to find this article because you were looking for a renovation loan or fix-and-flip commercial loan, you can submit your commercial renovation loan request to hundreds of hungry commercial construction lenders by clicking the button below:
The difference between a renovation deal and a fix-and-flip deal is that the fix-and-flip property will be offered for sale immediately upon completion. A property that is the subject of a renovation loan may, or may not, be sold upon completion. It might just be kept in the investor's portfolio and leased out for income. In either case, renovation deals and fix-and-flip deals are underwritten in exactly the same manner.
Renovation loans and fix-and-flip loans are underwritten just like commercial construction loans (or even residential construction loans). The only difference is that the Land Cost will include the cost of acquiring both the underlying land and the building in need of renovation.
An example will make this concept more clear. Suppose a property renovator ("the Flipper") spots an older rental house, zoned commercial, in need of repair on a busy commercial strip in an affluent area of town. He can buy the old rental house for $130,000, convert it into a cute little office building, and either lease it out or sell it for $325,000.
The house will need a new roof ($14,000), a handicap access ramp ($9,000), new exterior siding ($5,000), new paint ($8,000), new carpet ($6,000), and various repairs totaling another $7,000. Therefore the Hard Costs of the renovation will total $49,000.
There will also be Soft Costs of $22,000 for the appraisal, toxic report, loan points, title insurance, attorney's fees, closing costs, construction period interest, and leasing commission.
Every new construction loan or renovation loan needs a Contingency Reserve of around 5% of hard and soft costs. In this example, our Hard Costs are $49,000 plus our Soft Costs of $22,000 total $71,000. Five percent of $71,000 gives us a Contingency Reserve of $3,550.
Therefore our Total Cost is:
Land and Existing Building (old rental house) ... $130,000
Hard Costs .................................................. 49,000
Soft Costs ................................................... 22,000
Contingency Reserve .................................... 3,550
Total Project Cost ......................................... $204,550
So how much dough (equity) will the Flipper be required to contribute to this fix-and-flip deal? That's up to the lender. A reasonable loan-to-cost ratio in today's improving real estate market might be as high as 75%. Therefore a prudent commercial lender might be willing to make a new acquistion and renovation loan of 75% of $204,550 or $153,412.
Okay, so the Total Cost of the project is $204,550. The "construction lender" will make a loan of $153,412. Therefore the Flipper will have to cover the difference of $51,138.