Why acquisition lenders size on the lesser of price and valuation, and what a down-valuation does to the loan and the equity cheque.
On an acquisition, most commercial lenders apply the LTV to the lower of the purchase price and the lender's valuation. If an illustrative buyer pays 52.0 million for a building the valuer puts at 48.0 million, a 65 per cent LTV gives a loan of 31.20 million, not 33.80: the 4.0 million valuation shortfall costs 2.60 million of debt, and the buyer's equity rises from 21.32 to 23.92 million once purchase costs are counted.
Worked in full in Real Estate Finance by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The lender's security is the property, and what the property is worth to a lender is the valuation, not what one buyer was willing to pay. A price above valuation may reflect a competitive auction, a special purchaser or simply overpayment; none of it is recoverable in enforcement. A price below valuation, on the other hand, is the best evidence of what the market would actually pay today, so many lenders cap the loan at the LTV of the price too. Sizing on the lower of the two protects the lender in both directions, and it is common wording in acquisition term sheets: "the lesser of the purchase price and the market value".
| Input | Value |
|---|---|
| Agreed purchase price | 52.0 |
| Lender's valuation, market value | 48.0 |
| Maximum LTV | 65% |
| Purchase costs: transfer tax, fees, 6.0% of price | 3.12 |
| Net operating income | 2.64 |
Loan = LTV × MIN(purchase price, market value)
Equity = purchase price + purchase costs − loan
In Excel: =B3*MIN(B1,B2) for the loan and =B1*(1+B4)-B6 for the equity
Step 1: the sizing basis. MIN(52.0, 48.0) = 48.0. The valuation is the lower figure.
Step 2: the loan. 65 per cent × 48.0 = 31.20. Measured against the price, that is an LTV of 60.0 per cent; measured against the valuation, 65.0 per cent.
Step 3: the total cost. 52.0 × 1.06 = 55.12, including 3.12 of purchase costs, which the lender does not finance.
Step 4: the equity. 55.12 − 31.20 = 23.92, or 46.0 per cent of the price. Loan to total cost is 56.6 per cent.
The buyer had planned on 65 per cent of the price, 33.80, and equity of 21.32. The valuation takes 2.60 off the loan, which is simply 65 per cent of the 4.0 shortfall: every unit of valuation below the price removes 0.65 of debt, and the buyer has to replace it with equity. The debt yield on the reduced loan is 8.46 per cent, and the simple income yield, before purchase costs, is 5.50 per cent on value against 5.08 on price, a reminder that the valuer has capitalised the same income at a higher yield than the buyer paid.
If the lender had sized on price, the loan of 33.80 would sit at 70.4 per cent of the valuation on day one, above a 65 per cent LTV covenant before a single rent has been collected. Curing it would take a 2.60 prepayment, the same amount. Sizing on the lower of the two avoids lending into an immediate breach.
| Valuation against price | Valuation | Loan | Equity | Equity, % of price | Loan to cost | LTV on valuation |
|---|---|---|---|---|---|---|
| -10.0% | 46.80 | 30.42 | 24.70 | 47.5% | 55.2% | 65.0% |
| -7.7% | 48.00 | 31.20 | 23.92 | 46.0% | 56.6% | 65.0% |
| -5.0% | 49.40 | 32.11 | 23.01 | 44.3% | 58.3% | 65.0% |
| Equal | 52.00 | 33.80 | 21.32 | 41.0% | 61.3% | 65.0% |
| +5.0% | 54.60 | 33.80 | 21.32 | 41.0% | 61.3% | 61.9% |
| +10.0% | 57.20 | 33.80 | 21.32 | 41.0% | 61.3% | 59.1% |
The table is asymmetric. Below the price, the loan falls with the valuation and the buyer funds the gap. Above it, the loan is stuck at 33.80 and the extra value shows up only as a lower LTV, 59.1 per cent at a 10 per cent premium. A bargain purchase works the same way: buying at 45.0 a building valued at 48.0, the lender lends 29.25, not 31.20, an LTV on value of 60.9 per cent. The buyer gets the headroom, not the cash, until it refinances on a later valuation.
Size the acquisition loan on MIN(price, valuation) and fund purchase costs with equity: 65 per cent of 48.0 is 31.20, and the 4.0 overpayment becomes 2.60 of extra equity. The book is about what a property is worth to a lender, and the free workbooks for the book put four values for the same building side by side. For what LTV level to aim at, see what a good LTV is for a commercial loan.
The loan is sized on the appraisal, so the buyer funds the shortfall times the LTV in extra equity, or renegotiates the price. In the illustrative case a 48.0 million valuation against a 52.0 million price cuts a 65 per cent loan by 2.60 million, to 31.20 million.
Usually not on an acquisition: many lenders cap the loan at the LTV of the price too. Buying at 45.0 million a building valued at 48.0 million, a 65 per cent lender lends 29.25 million, not 31.20, which is 60.9 per cent of value. The extra headroom becomes borrowable only on a later refinancing.
No. Loan to cost divides the loan by the price plus purchase costs. On the illustrative deal the 31.20 million loan is 60.0 per cent of the price, 65.0 per cent of the valuation and 56.6 per cent of the 55.12 million total cost.
This article is one calculation from Real Estate Finance. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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