Think like a lender so you can avoid borrowing traps

These are unprecedented times with historically low interest rates. Under these conditions, the time is ripe for buying commercial property. Even in this favorable time, it is important as a borrower to plan when seeking lenders. The first step is to think like a banker/lender. What does the banker need to consider in this scenario? Well ... the banker needs to minimize his risk in the evaluation of your credit worthiness.

Some bankers describe this evaluation as determining whether you are “bankable” within their guidelines. Please note: The banker has colleagues in the shadows, the underwriting department, who he must convince that you are bankable for the financing of the commercial property in question. The banker will look at five areas in evaluating your credit worthiness. Many bankers refer to them as the “The 5 Cs.” This may be an old-fashioned term, yet it is instructive for readers who are considering this financially intense exam. The 5 C’s are Capacity, Capital, Collateral, Conditions, and Character. Let’s review the 5 C’s.

Capacity test answers the question: Does the borrower have the wherewithal to pay back the loan? The common trap in Capacity is that the borrower makes the following assumption: They can cover their borrowing costs without going through a proper cash-flow coverage computation. The errors usually are that the borrower overlooks regular and recurring costs in the analysis. Moreover, the borrower may not include a repair and maintenance reserve in the cash flow coverage calculation.

Bankers consider this test as the ability, in good and not-so-good times, to service the loan through its term. Most commercial property loans are 15- to 20-year terms. The banker evaluates your current cash flow on a monthly basis. The analysis, on a business and individual level, measures whether you have proper cash-flow coverage. Cash flow coverage is defined as adding all cash inflow, revenues from rent and other sources, minus all monthly expenses. The banker then computes a ratio analysis. Bankers use a cash flow coverage ratio that range from 1.30 to 1.40 with commercial property cash-flow which means that the net cash flow must be 130 percent to 140 percent over the monthly loan payment — principal and interest.

Capital is the test where the banker analyzes your business and personal assets to determine how much overall debt to asset values you currently hold. It involves a ratio analysis as well. Some bankers refer to this analysis as a debt-to-equity analysis. Equity is a term used to determine the value of personal and real estate investments you hold. The Capital trap is that the borrower does not have a realistic view of the fair market value of the commercial property or has unrealistically high perception of his overall personal net worth, in excess of all business and personal debt.

The banker analyzes your entire assets less your total personal debt outstanding. They evaluate three areas of debt to equity: they look at your personal financial information, your business financial debt to equity and your commercial property debt to equity ratio.

Collateral tests the loan compared to the fair market appraisal of the commercial property. The loan-to-value test is based on the property appraisal. A common trap is that the borrower has an unrealistically high perception of the fair market value of the property. If the loan to value is higher than 65 to 75 percent, the probability of a bankable loan is low in this market environment. It is important to have a good understanding of the methods that appraisers use in appraising commercial property. There are three methods: building replacement cost, market comparisons (comps), and monthly net income analysis. They typically blend all methods to appraise the property. In my experience, bankers give the green light on loans to commercial property with at maximum 65 percent to 75 percent loan to property fair market value

The Conditions test reviews the local economy and the borrower’s financial and emotional condition including income stability and expectations of stability during the loan time frame. A common trap is that the borrower’s perception of the loan terms is overly optimistic.

Recently, a colleague of mine shared that his client was emerging from a difficult cash-flow period where his company was reporting a loss for two of the past three years. He wanted to refinance his building loan. His expectations were that his bank would accept the refinancing with little hesitation. The bank denied the loan due to his financial history for the past three years. The client was not able to refinance until his business growth track record stabilized.

The test of Character encompasses all 5 Cs. When you hear the sports-related comment that the athlete has a strong, stable character, what images come to mind? To a typical banker, a person with a strong, stable character is one who has integrity and a lifestyle that is consistent with paying back loans even in difficult times. When a borrower is highly in debt, or as defined in banker terms — highly leveraged, the banker questions the borrower’s character.

A common trap is that borrowers have excessive personal debt and have a tendency to behave with instant gratification for unnecessary purchases in general. As a colleague of mine noted, bankers are in the business of renting money. They prefer to rent money to people who take borrowing as a high priority, a top personal responsibility.

The banker’s 5 Cs are the critical success factors for borrowers. These tests, in the banker’s mind, mitigate his risk and maximize his opportunity to provide a safe loan for the bank. The traps of the borrower can be avoided with proper planning and understanding of the banker’s view in financing commercial property.

Scott T. Wait, CPA, is partner in RS Wait, Chtd. of Reno. Contact him at 775-825-7337 or;


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