What is Loan to Value Ratio?
Loan to value ratio measures how much debt is held against the current value of the asset. LVR or LTV is a quick snapshot on the inherent leveraging risk.
LTV can be useful tool in evaluating the riskiness of an investment. The greater amount of debt is used verses the asset value means that investors should demand a higher risk. Listed industrial companies typically utilize 20% to 30% loan to book asset value. While private equity uses up to 75% of debt finance in acquisitions.
Another important metric which measures the level of indebtedness is the interest coverage ratio. The interest coverage ratio shows how much of the current asset income covers total interest paid against the borrowing.
Using the same example above, if the asset generates $100,000 in income and interest expense $50,000 then the coverage ratio is 2. ($100,000/$50,000).
You can use the LVR calculator above to calculate the Loan to value ratio.
Debt can magnify return as well as increase the risk. Investors must understand that leverage in this context not only enhance returns but also risks. It is double edged Leverage can be your friend in up markets and enemy when asset values are falling.
Investors need to understand the sensitivity the level of debt can magnify movements in asset prices on investor equity.
From downside protection perspective the higher level of debt means that the lower amount of asset value has to move to wipe out the equity in the investment.
The chart shows the percentage fall required in the asset value before equity is wiped out.
At 95%, the asset only has to fall 5.26% to reduce investor equity to zero. If 70% of the asset value is debt financed, the asset has to fall 42.86% before reducing total equity to zero. Sometimes lenders will require additional collateral will be required before zero.
The higher the debt LVR, the lower cushion the investor has if asset prices moves against you.
LVR Borrowing Capacity
Mortgage LVR are typically around 80% of on the value of the house. Any higher and the lender would cost more in terms of interest rates as well as requirement in taking out a mortgage lending insurance to compensate for the risk. Important to note that LMI premium is paid by the borrower and not the lender and the insurance covers the short fall the lender faces when selling the collateral falls short of the amount borrowed.
The lender uses a number of factors listed below in determining the total capacity:
- Borrower income – income plays the largest factor in determining total borrowing limit. High income plays a factor but also the breakdown of income from salary and other investment income. Depending on the bank some would put more weight and reliance on salary than dividend or capital gains.
- Living expenses – each bank would have its own benchmark in living expenses for singles and couples so there is a lower limit on expenses that the bank would use in determining borrowing capacity.
- Other credit loans- these include other personal loans, margin loans, credit cards or unsecured loans
- Assets – depending on the asset. The most standard asset, the ease more lenders will be willing to lend against it. Usually it is not an issue for houses but some lenders do not like apartments smaller than 50 square meters. Buying these kind of asset would limit the potential lender pool.
- Other asset – if the individual has other assets this would be a factor. For those that are borrowing for investment should also be aware of the risk in cross collateralization of loans.
Using Leverage in Trading and Investing
For property investors the saving grace is that real estate is rarely marked to market. This means investors are more comfortable in using higher ratio in the process. Listed assets which are exposed to market volatility does not have the same luxury. Since asset values changes on a daily basis. There is a lot more monitoring and work in managing the positions.
Even in the equity portfolio. Leverage can be a different role in trading and investing.
We use leverage meaningfully in our portfolio however we have tight stops on trading positions and low overall leverage in the investment positions so we are not shaken out of our position when markets are volatile.
Our approach is using leverage dynamically where we do not have a target loan to value ratio or leverage ratio. Instead we are conscious of the total debt in the portfolio and the leverage is depending on opportunities irrespective of market conditions.
As market value of the portfolio increases. It does not automatically mean that the use of margin debt increase. Rather it means if there are opportunities to deploy the capital we will but only going forward cautiously.
During down markets we would be more cautious. However as opportunities present it self we feel there is alot of value in taking counter cyclical positions. After all during stock market crashes is the only time when there is sale but investors run the other way. Leverage is used only marginally to increase returns with the goal of limiting the impact in volatility.