LVR, ICR, DSCR and other lending ratios

Why lenders reach for ratios

A lender deciding how much to advance needs a quick, consistent way to judge two things: how well the loan is covered if the security has to be sold, and whether there is enough income to keep the loan running in the meantime. Ratios answer both questions by expressing one amount as a proportion or multiple of another. They let a credit team test a deal against its policy and keep testing it while the loan is outstanding.

The ratios below fall into two families. The first measures the loan against an asset or a cost. The second measures it against income. This lesson explains each one in words; when you want to try real numbers, the LVR and loan-to-cost calculator and the interest cover calculator do the arithmetic for you.

Ratios that measure the loan against security or cost

Loan-to-value ratio (LVR)

If you are looking for the loan to value ratio explained simply, it is the debt divided by the value of the property securing it, shown as a percentage. The deceptively simple part is deciding which debt and which value. On the debt side, some lenders count only the cash advanced, while others include fees, retained interest or interest expected to be capitalised. On the value side, lenders use the figure from a valuer they instruct, and when you are buying, some measure against the lower of that valuation and the contract price. Your own estimate does not enter the calculation. The glossary entry on LVR and the lesson on valuations explain how value is assessed.

For a property that will change, such as a renovation or a development, the lender may calculate one LVR against the current state of the property and another against its expected value once the work is complete.

Combined LVR

Combined LVR adds together every loan secured on a property, including any first mortgage, second mortgage or caveat-backed loan, and compares that total with the value. A first mortgagee generally cares about its own loan. A lender holding second-ranking security is repaid only from whatever is left after the first mortgagee is paid out, so the combined figure is the one that tells it how much buffer remains. If you are considering second mortgage loans, expect the combined figure to drive the conversation.

Loan to cost (LTC)

Loan to cost compares the loan with what a project or purchase costs, rather than with what it will be worth. In development, cost usually covers land, construction, consultants, approvals, contingency and finance charges. The ratio shows how much of that budget the lender is funding and therefore how much the borrower must contribute as equity or from another source. Construction lenders frequently apply a loan-to-cost limit alongside a limit measured against gross realisation value, and whichever produces the smaller loan generally applies. The construction finance page covers how those limits interact with progress draws.

Peak debt

Peak debt is not a ratio in itself but the figure many ratios are tested against. It is the highest balance the loan reaches over its life. In a staged construction loan, that point usually arrives near completion, once every progress payment has been drawn and interest has been added along the way. In a bridging loan, it is the period when both properties are financed at once. Lenders size the loan for this moment because it is when their exposure is greatest, which is why a project that runs late, with interest still accruing, can push a deal outside policy even though nothing else has changed.

End debt and refinance tests

Short-term lenders also look past the peak to what remains once the exit event happens. In bridging, that is the end debt left after the sale proceeds are applied. In development, it may be a residual stock loan or a refinance of unsold units. Lenders often apply a separate LVR test to that remaining balance, because it shows whether the exit can realistically clear or refinance the loan.

Ratios that measure the loan against income

Interest cover ratio (ICR)

The interest cover ratio asks how many times a property's net operating income covers the interest payable over the same period. It is expressed as a multiple rather than a percentage. Net income generally means rent received less the outgoings the owner bears and the tenant does not reimburse. Lenders use interest cover mainly for commercial, industrial and retail property, where rent is the primary source of payments. Some test it at an assessment rate above the rate you will actually pay, to allow for future rises.

Debt service cover ratio (DSCR)

The debt service cover ratio uses the same income figure but compares it with total debt service: interest plus any scheduled principal repayments. Because principal is included, DSCR is the tougher of the two tests whenever a loan amortises. For owner-occupied business premises, a lender may measure DSCR using the trading business's earnings rather than rent, since the business itself is paying the loan.

How the ratios work together

Lenders rarely rely on a single measure. A commercial lender might apply an LVR limit and a minimum interest cover; a construction lender might combine loan to cost, a limit against completed value and a peak debt test. Each limit produces a maximum loan, and the smallest of those maximums is the binding constraint.

Order matters less than definitions. Two lenders quoting the same LVR limit can still offer different amounts if one counts capitalised interest in the debt and the other does not, or if one measures against an as-is value while the other uses a completed value. Reading how each ratio is defined in the term sheet is as important as reading the limit itself.

Here is a worked description in words. A hypothetical investor wants to buy a leased warehouse. The lender first works out the largest loan its LVR limit allows against the valuation. It then takes the net rent, applies its assessment rate, and works out the largest loan that still meets its minimum interest cover. If the rent is modest compared with the price, the interest cover test produces the smaller figure and caps the loan, even though the LVR test alone would have allowed more. The investor can either contribute more equity or look for ways to support the income case. Enter your own figures in the interest cover calculator and the LVR and loan-to-cost calculator to see which constraint bites first.

Ratios as ongoing covenants

Many commercial and development loans turn ratios into covenants that are tested during the term, not just at the start. An LVR covenant may be checked against a fresh valuation, and an interest cover covenant against updated rent figures. A tenant leaving or a fall in values can cause a breach even when every payment has been made on time. Depending on the agreement, a breach may lead to a review, a demand for extra security or a partial repayment, or a default. The lesson on default and enforcement explains what can follow.

Common mistakes

• Calculating LVR from the price you hope to achieve rather than the lender's valuation.
• Leaving capitalised interest and fees out of the debt figure, which understates peak debt.
• Using gross rent instead of net income when estimating interest cover.
• Overlooking whether a completed value is measured including or excluding GST.
• Assuming every lender defines a ratio the same way; definitions in the term sheet can differ.

What to ask a lender

1. Which value do you measure LVR against, and do you use the lower of valuation and price?
2. Do you include fees and capitalised interest in the loan side of the ratio?
3. What minimum interest cover or debt service cover do you require, and at what assessment rate?
4. Which limit is binding on my application?
5. Are any ratios ongoing covenants, how often are they tested, and what happens if one is breached?