How to use LVRs to weigh up private debt risk
Buying property isn’t the only way to capitalise on Australia’s red-hot property market. You can also invest in the underlying debt, effectively “becoming the bank”. But how do you measure the risk? One way to find out is by looking at LVRs – Loan to Value ratios – to weigh up potential risk and return.
Like any investment, it’s important to look into the trade-off between risk and return. When you invest in real estate debt, you have the potential to enjoy a reliable return in the form of monthly interest payments – similar to a fixed-income investment.
But what about your capital? How is that secured? There are several factors related to capital security in a private debt deal – one of which is the LVR.
Why look at LVRs?
LVR is the size of the loan relative to the value of the property securing it, reflected as a percentage. LVR is calculated by dividing the loan amount by the value of the property and then multiplying by 100. So, a $500,000 loan on a property valued at $900,000 represents a 55.50% LVR.
The lower the LVR, the more ‘buffer’ there is to protect your investment in the event the property needs to be sold.
Lenders often use LVR to help assess the risk of a property loan. When you invest in the underlying debt, you become a de facto lender, so LVR is an important tool for evaluating your investment risk/reward.
Finding the right LVR mix for you
1st mortgage secured debt investments are paid in priority to second mortgages (in both interest and capital), so while you may forgo some of the upsides of property investment, such as capital gain, you enjoy priority of repayment.
“Sometimes I’ve had a return around 6.50%, with an LVR just below 60%,” one of our investors told us. “And if it’s a short period, it’s better than doing nothing in the bank.”
Investors sometimes choose to diversify within their private debt investments, looking for a balance between lower and higher LVRs. Or they may just feel comfortable with a set target – say 65% and no higher. The ideal loan-to-value ratio depends on the investor’s “personal sleep-at-night factor,” another investor says.
“There are other companies that might offer a bigger percentage return – but as that return goes up, there’s more risk,” he said. “I’m not greedy. I’m happy with what I get from AltX. It’s all very nice in theory to get 10% or 11% p.a. return, but then the LVR could be 75% or 80%. And if something happens, it could be a disaster. I prefer to sleep at night.”
Adding LVR to your research mix
LVRs are only one part of the risk equation. You also need to do your homework on other risk factors, some of which include:
- Getting property valuation right – an essential ingredient in determining LVR.
- The borrower’s cash flow and credit history – how much confidence do you have in their ability to pay the interest?
- Underlying security – the quality, value and liquidity of the asset itself.
- Loan exit strategy – how will the loan be repaid within the fixed timeframe? This is normally done via a refinance, sale, or other cash injection.
As one of our investors put it, it’s important to look at each deal on its own merits.
“I do quite a bit of research into the transaction – and only look at LVRs of 65% or less. And when you’re getting anywhere between, say, 6.00% and 7.00% return on your money, that stacks up well against a term deposit.”
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