COMMERCIAL LOANS
Article written by Brian O’Connor, Economic Development Specialist, Texas Main Street Program/Courthouse Square Initiative
To a large extent, commercial banks influence the business mix in many Main Street communities. Accordingly, commercial lenders play an under appreciated role in deciding which businesses are worth pursuing and deserving of capital. Since many of us have purchased a house or car, it’s easy to presume that we’re familiar with the commercial lender’s perspective. However, while there are many similarities between consumer and commercial loans, there are distinct differences worthy of mention.
Residential borrowers are qualified based on their income and credit score and are told how much house they can afford. The value of the house is determined by an appraisal that looks at recent sales of similar property in the neighborhood. Commercial borrowers are qualified by their financial profile that includes how much income the subject property generates compared to similar properties.
As Main Street managers, the most common commercial loans you’re likely to encounter are: 1) for the purchase or construction of real estate; 2) refinance options that arise as interest rates drop or when a property owner wants to pull equity from a property; and 3) bridge financing when a borrower is purchasing or refinancing a property. As commercial bankers are not investors, their lending practices reflect the risk they are willing to accept when evaluating the credit factors of each of these type loans. Understanding how commercial lenders assess a borrower’s credit worthiness can help determine the type of programming and services that Main Street communities offer.
One of the ways that commercial lenders evaluate a borrower’s credit worthiness is by their geographic location. The rationale is that the larger the population, the more resilient the property is to the pressures of business cycles and the stronger the resale opportunity of the collateral. Commercial lenders also take into consideration whether the property is owner-occupied or non-owner occupied. These distinctions are important to understand because of how the income stream from the property is evaluated by the lender.
Commercial banks make money by collecting interest on loans and paying interest on core deposits. Therefore, a bank has typically less than a 3 percent net interest margin … the difference between what it pays depositors and its loan rates. Therefore, part and parcel of a bank’s lending practices is its ability to evaluate a borrower’s credit worthiness and to charge different rates of interest based upon that assessment. Oftentimes, the best possible outcome for a commercial bank is to get paid back its principal with a small spread on the interest.
When considering a loan, commercial lenders evaluate the borrower’s income, assets and debt. Part of the lender’s financial analysis is to review several years of audited financial statements, tax returns, and contracts with customers, distributors, vendors, and suppliers. To minimize risk, most commercial lenders will only finance businesses that have at least 2-3 years of operations. Commercial banks do not generally finance startup businesses, as they have no historical financial performance. Today, approximately 57 percent of all startups are self-funded. The most common funding sources for business startups are friends and family, credit unions, credit cards, and the Small Business Administration.
After obtaining a consumer loan, the lender only requires that the borrower make timely monthly payments. With a commercial loan, even if the borrower makes all its payments in a timely manner, the lender will still require annual financial statements and proof of insurance on the collateral. Some commercial loans contain provisions that allow the bank to call the loan, if it believes changing market conditions place the loan in jeopardy. To a lender, collateral is viewed as a safeguard, not as a repayment source.
Naturally, commercial lenders evaluate the physical condition of the collateral when evaluating risk. Accordingly, commercial real estate is divided into categories A through C. Class A property is the most desirable as it possess the best location and amenities. Class B characterizes most commercial real estate that is currently usable. Class C properties typically suffer from neglect, are located in less than desirable neighborhoods, and pose the greatest risk.
An important factor in how the lender decides the interest rate of the loan is whether the local real estate market is stabilized. This means that the occupancy rate for the market is steady at 92 to 95 percent. Is it little wonder that an owner of a functionally obsolete building located in a small community with high vacancy rates cannot obtain competitive financing? These credit factors not only affect a property owner’s ability to obtain competitive financing for building improvements but also impact a growing businesses ability to secure lines of credit for working capital.
Since the essential element of any commercial loan is cash flow, the lender likes to see a healthy cash flow so the borrower can handle any financial crisis. Specifically, the property must generate enough cash flow to cover all property expenses plus the new loan payment. Commercial lenders typically require a debt service coverage ratio (DSCR) of 1.20, meaning, for every dollar ($1.00) in debt, the property contributes one dollar and 20 cents ($1.20) in cash flow to support the mortgage payment. While the lender’s primary concern is the borrower’s ability to make the monthly payment, they also evaluate the depth and liquidity of the borrower’s total assets should the cash flow from the business decline.
Even with an established business, commercial lenders will require a business plan describing the business model, competitive landscape and marketing strategy, management, and financial projections. Lenders want to see how you are going to use the loan proceeds and how the loan will help your business make money to repay the loan.
A commercial lender performs a financial analysis to gain a complete picture of how well the business is generating a profit, and its likelihood of continuing in business. The lender’s scrutiny often leads to a lasting relationship, in which the banker helps the business maintain a healthy financial position. The better we understand the lender/ borrower relationship, the stronger advocates you can be as Main Street managers.