COMMERCIAL LENDING 101
OVERVIEW
Many people understand the underwriting requirements for residential mortgage lending. However, just as many people, if not more, do not have the same understanding of commercial mortgage lending. The reasons given include that it is new to them and/or it is normally not explained by lenders to their customers. Therefore, people are not typically as comfortable with the process and do not know what to expect. Direct Credit Advantage is here to help.
Below is a general guideline for small to medium sized businesses seeking commercial, owner-occupied real estate financing. This guideline will not only help you obtain commercial mortgages but will also provide you a platform to analyze your business.
Generally, a lender analyzes some combination or form of the 4 “C’s” of commercial lending to determine if and how much it is willing to lend on a given project. The 4 “C’s” include:
- COLLATERAL
- CASH FLOW
- CREDIT/FINANCIAL ANALYSIS
- CHARACTER/MANAGEMENT
Through an evaluation of each of these areas, a lender will determine the level to which each “C” is satisfied in comparison to its requirements.
Our discussion and description of these areas are meant to provide a general overview and are intended for informational purposes only. Each lender is unique, and although most commercial mortgage lenders generally evaluate projects using the main criteria described herein, a lender may organize criteria in a different manner than that outlined and have different satisfaction requirements than those described herein. Additionally, different lenders place their own level of importance on any given area to determine their interest in a financing project. Different lenders may also allow strength in one area to completely or partially offset a deficiency in another. In addition to the 4 “C’s” of commercial lending, a lender may also incorporate other factors into its decision making process, such as its rate of return on a project, industry specific requirements, or a business’ industry.
COMMERCIAL LENDING 101: COLLATERAL
COLLATERAL is generally defined as an asset used to provide security for a lender’s loan. Collateral may be seized and sold by a lender to help repay a loan in the event of default by a borrower. In commercial mortgage lending, collateral usually consists of the commercial real estate and improvements, which includes land, building and fixtures, which the business is buying and/or refinancing. Depending on the project and type of collateral being offered, a lender will generally be willing to provide a maximum loan in the range of 50% to 90% of the value of the collateral for a real estate loan (50% to 90% loan to value).
The value of collateral for a loan is a key component in determining how much money a business can borrow. In the case of a new property acquisition, collateral value is usually determined by using the lower of cost or appraised value. However, if you already own a property being financed, a lender may utilize the appraised value of the property to determine the maximum amount of a loan. A lender’s willingness to do this will usually depend on your length of ownership and generally is permissible with at least one to five years ownership. Different lenders will have their own appraisal requirements. Before engaging an appraiser, you should always check with your intended lender to ensure that its appraisal requirements are being met.
In addition to its value, real estate collateral is generally classified into two primary categories:
- Multipurpose: This type of collateral can be used by a wide variety of businesses without substantial changes (e.g., office buildings, warehouses, etc.).
- Special Purpose: This is defined as property that can only be used by only one or a few businesses without substantial changes being made (e.g., gas stations, car washes, hotels, etc.).
Categorization of collateral into one of the above areas usually determines a lender’s maximum loan to value. The more specialized the property, the lower a lender’s maximum loan to value.
In addition to the above, there are other factors which may or may not already be factored into an appraisal value or collateral categorization that a lender may use to determine maximum permissible loan to value:
- Location
- Age
- Condition
- Type of Construction
- Alternate Uses
- Visual Inspection
- Potential for or Presence of Environmental Contamination
- Easements
At a minimum, any given lender will typically utilize its own unique combination of most or all of the areas discussed here to determine the maximum permissible loan to value for your project.
COMMERCIAL LENDING 101: CASH FLOW
CASH FLOW ANALYSIS is used by a lender to evaluate the ability of a business to repay debt with a comfortable margin. There are two primary types of cash flow a lender may analyze in order to determine this figure, and a lender may use either or both types to perform its analysis.
The first type is traditional cash flow. Traditional cash flow is calculated from the annual profit and loss statement using the following formula:
Earnings before taxes
+ Interest expense
+ Depreciation expense
+ Amortization expense
+ Other non-cash expense items
+ Any non-recurring expenses
= Traditional Cash Flow
An example of a non-recurring expense would be rent if the business were moving from a leased space to an owner occupied space. The resulting traditional cash flow figure is also commonly referred to as earnings before interest, taxes, depreciation and amortization (or EBITDA) plus other non-cash expense items and any non-recurring expenses.
The other type of cash flow analyzed by lenders is actual cash flow. Actual cash flow is determined through utilizing a business’ Statement of Cash Flows and the line item known as “Cash Flow from Operating Activities.” However, in a large number of instances a Statement of Cash Flows is not prepared by a small business’ controller or CPA. Therefore, many lenders utilize the balance sheet and profit and loss statements of a business to build a Statement of Cash Flows and calculate “Cash Flow from Operating Activities.” Besides normal profit and loss items that affect cash flow, balance sheet items may affect this calculation. This can include items such as changes in inventory levels, accounts receivables, accounts payables, etc. As with traditional cash flow, certain adjustments are also made to “Cash Flow from Operating Activities” including adding back:
- Interest expense
- Non-recurring expenses
In some cases, a lender may also subtract provisions for additional items from traditional and actual cash flow figures. These may include items such as owner/outside party management fees; capital expenditure reserves; and furniture, fixtures and equipment replacement reserves. The amount and type of additional provisions subtracted from cash flow are typically a function of the type of business being financed.
A Lender will also typically utilize the traditional cash flow figure as its basis in evaluating a business’ ability to make annual debt payments. Lenders quantify the business’ ability through the use of the debt service coverage ratio. This ratio is defined as follows:
Traditional Cash Flow
Annual Debt Payment
The annual debt payment figure is the sum of all annual debt obligations the business will have at or around the time the commercial mortgage will close. For example, a business currently has a line of credit and equipment financing and is planning on buying a property to locate its office and some new equipment. A lender would determine the annual debt payment figure by summing the:
- Annual interest on the line of credit,
- Annual principal and interest payments on the existing equipment financing
- Annual principal and interest payments on the new office financing
- Annual principal and interest payments on the new equipment financing
Generally, lenders have a required minimum debt service coverage ratio that may range from a low of 1.0:1.0 to as high as 1.5:1.0. It should also be noted that in the case of a substantial change in business, such as an expansion or a start up business, debt service coverage ratio requirements may be different and a lender may also consider projected cash flow in its calculation of debt service coverage ratio. In these cases, cash flow from other sources, such as another business you own outside of the project being financed, may also be used as additional support for the calculation of debt service coverage ratio.
As previously mentioned, some lenders also calculate actual cash flow. These lenders alternatively utilize a business’ actual cash flow figure to calculate debt service coverage ratio. Other lenders may compare a business’ actual cash flow figure to its traditional cash flow figure to determine if the two closely correlate. If the two are not closely correlated, additional adjustments may be made to traditional cash flow to more accurately calculate debt service coverage ratio.
COMMERCIAL LENDING 101: CREDIT/FINANCIAL ANALYSIS
Lenders utilize Credit/Financial Analysis in conjunction with cash flow analysis to determine a business’ financial history and overall financial strength.
Typically, a lender will obtain a business credit report, such as a Dun and Bradstreet Business Information Report, for an overview of a business’ credit history. A report such as this will typically provide a classification of the business which is determined by its size and its payment history with trade creditors. The report may also reflect any outstanding liens and judgments or pending lawsuits which may adversely impact the current or future prospects of the business and will provide a brief history and description of the business. Aside from an obvious reflection of weak financial performance, a poor repayment history on business debt may also be representative of lack of management ability and/or character, which is discussed further under Character/Management.
A lender will also obtain a personal credit report to see how much personal debt the primary owner of the business is carrying and his/her payment history on personal debt obligations. In doing so, a determination can be made as to whether or not the business’ owner is taking an adequate salary to cover his/her personal debt obligations. If the owner is not taking an adequate salary, then cash flow of the business may be reduced accordingly. On the other hand, if the owner is taking a more than adequate salary, then a positive adjustment may be made to cash flow. Poor payment history on personal debt obligations may also be representative of poor management ability or character which is discussed further under Character/Management.
Lenders perform financial analysis on a business in an effort to assess and identify financial strengths and potential or existing financial weaknesses not necessarily reflected by a business’ repayment ability or credit history. A lender will usually perform financial analysis on three full years of financial statements and if applicable, a current year interim financial statement dated within sixty to ninety days. Projected financial statements may also be included in financial analysis.
Financial analysis involves calculating financial ratios from items on a business’ balance sheets and profit and loss statements. Current performance can be determined for a variety of financial measures and improving or worsening trends can be revealed. Some financial ratios can also be compared to industry standards for the business obtained through publications such as The Risk Management Organization or RMA (formerly known as Robert Morris Associates) Annual Statement Studies. This allows the lender to compare a business’ performance to its industry.
The following Liquidity, Leverage, and Performance ratios are among the most common that may be used by a lender in its analysis:
- Liquidity Ratios – provide an analysis of the quality and adequacy of current assets and their ability to fund current liabilities as they come due.
- Current Ratio – is an indication of the business’ ability to fund current liabilities with current assets. The ratio is defined as:
Current Assets
Current Liabilities
The higher the ratio, the greater the business’ ability to fund current liabilities with current assets.
- Quick Ratio – is an indication of the business’ ability to fund current liabilities with the most liquid current assets. The ratio is defined as:
Cash & Equivalents + Net Trade Receivables
Current Liabilities
If the ratio is substantially less than current ratio, then the business has a dependency on non-liquid current assets, such as inventory, to fund current liabilities.
- Days Accounts Receivable – provides an estimate of how long it takes the business to convert a sale to cash. Normally, this ratio is also cross-referenced with an Aging of Accounts Receivable. This ratio is defined as:
365 x Net Trade Receivables
Net Sales
The lower the number, the fewer days it takes to convert a sale into cash.
- Days Payable – provides an estimate of how long it takes the business to pay its trade creditors. Normally, this ratio is also cross-referenced with an Aging of Accounts Payable and the Dun and Bradstreet Report. This ratio is defined as:
365 x Trade Payables
Cost of Sales
The lower the number, the fewer days it takes the business to pay its trade creditors.
- Inventory Turnover – provides an estimate of how many times inventory is turned over by a business during a typical operating cycle. The ratio is defined as:
Cost of Sales
Inventory
The higher the number, the greater the number of times inventory is turned over by a business.
- Days Inventory Turnover – provides an estimate of how long inventory is held by the business before it is sold. The ratio is defined as:
365 x Inventory
Cost of Sales
The lower the number, the fewer days it takes the business to sell its inventory.
- Leverage Ratios - provide an indication of the amount of financial leverage utilized by a business.
- Debt to Worth – compares the capital contributed by creditors to capital contributed by owners and generated by a business through operations. The ratio is defined as:
Total Liabilities
Net Worth
The higher the ratio, the more leveraged the business and the greater the risk assumed by creditors.
- Debt to Tangible Worth – compares the capital contributed by creditors to the tangible capital contributed by owners and generated by a business through operations (tangible worth). Tangible worth is defined as net worth less intangibles assets (e.g., patents, trademarks, organizational costs, etc.). The ratio is defined as:
Total Liabilities
Tangible Net Worth
The higher the ratio, the more leveraged the business and the greater the risk assumed by creditors.
- Performance Ratios
- Common Sizing – This is used to compare the different line items of the balance sheet and profit and loss statements. Common sizing of the balance sheet is accomplished through dividing line items by total assets in the same year. Common sizing of the profit and loss statement is accomplished through dividing line items by net sales in the same year. Individual line items can be analyzed in each individual period and significant fluctuations in line items can be identified over multiple periods.
- Return on Assets – identifies a business’ return in relation to its total asset size. This measure is usually expressed as a percent. The ratio is defined as:
Profit before Taxes
Total Assets
The higher the figure, the higher the productivity generated by a business’ management from its use of business assets.
- Return on Equity – identifies a business’ return in relation to its equity capital. This measure is usually expressed as a percent. The ratio is defined as:
Profit before Taxes
Net Worth
The higher the figure, the higher the productivity generated by a business’ management in relation to the business’ equity capital. A high return on equity can also be representative of the use of high leverage (too much debt).
- Return on Sales – identifies a business’ return in relation to its net sales. This measure is usually expressed as a percent. The ratio is defined as:
Profit before Taxes
Net Sales
The higher the figure, the higher the proportion of net profit that results from sales.
COMMERCIAL LENDING 101: CHARACTER/MANAGEMENT
For most small to medium sized businesses that are owner-managed, the owner’s management ability and character are, of course, the primary focus of a lender’s evaluation in this area. However, there are many other factors that can adversely or positively impact a lender’s assessment. These can include items such as the presence and ability of secondary managers and other key employees, availability of replacement management, availability of management resources, and the complexity of management duties. Collectively, these areas are examined by a lender in order to:
- Obtain reasonable assurance that adequate management ability is already present or is readily available to operate the business;
- Obtain reasonable assurance that the business is being operated in an ethical and legal manner; and
- Evaluate the willingness of a business’s owner to repay debt and meet other obligations.
In assessing management ability, generally a lender will examine a person’s qualifications in certain key areas. Among the factors that could be considered are educational background, industry experience, direct experience with the business being financed, past management history, and experience managing a business of like or similar type. Usually, a lender prefers to see that the owner of a business has a minimum of three to five years of direct experience with the business being financed, ownership and management of a business within the same or similar industry, or substantial management experience with a business within the same or similar industry.
Another method of assessing management ability is through the use of a business credit report and a personal credit report for the business’ owner. These credit reports were discussed in more detail in the Credit/Financial Analysis portion of this discussion. Lenders will usually examine the credit score and look for the presence of any derogatory information on the report including judgments, garnishments, late payments, etc. that can be indicators of management deficiencies. A poor business or personal credit history is usually a clear sign of management’s inability to operate a business in a manner sufficient to make timely payments to creditors.
A lender can also evaluate character through the use of a business credit report and a personal credit report for a business’ owner or for a key employee. Again, these credit reports were discussed in more detail in the Credit/Financial Analysis portion of this discussion. Derogatory information contained on either report, i.e. lawsuits, judgments, etc. can be indicators of unethical or adverse business practices. Additionally, a poor business or personal credit payment history can also be a strong sign of poor character, particularly when a business or individual possesses adequate resources to make timely payments to creditors but does not.
Other methods of character investigations utilized by lenders include background forms or questionnaires, checks of public records, criminal background checks, and the use of private investigators.
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