In today’s financing markets, capital is not quite as plentiful as it once was. Those institutions that have capital to lend have come under increased levels of scrutiny and regulation, and because of that have become much more conservative in how and to whom they lend that capital. If you are a commercial loan borrower looking to utilize their capital, it is important to understand how that capital works. Understanding the pressures banks and financial institutions are under and the risk / reward model they use for their capital, is a key to understanding how to position your loan request. It is also important in understanding how and why commercial lenders react the way they do, and to get insight into how you can expect your banking and lending relationship to be managed going forward.
The primary source of commercial financing within the United States today is still commercial banks. Although there are a number of other lending sources including government programs, insurance companies, conduits, private lenders, and other specialty lending sources, the vast majority of commercial loans are made by commercial banks, and it is with commercial banks that just about all commercial loan borrowers start. Because of this, most of the focus in this Chapter will be about the capital requirements of commercial banks, although we will briefly touch on how the other lending sources work towards the end of this Chapter.
So lets get started talking about commercial banks. Commercial banks like any business start-out with capital. Without starting capital a company would not have the funds to buy equipment, make payroll, or in the case of commercial banks, lend money. Capital for Bank’s can take many forms. For small community banks it is often either family money or local investor money where the investors own private stock in exchange for the capital they have invested into the Bank. For larger regional banks capital usually comes from a wider variety of sources including management, private investors, ownership, larger private funds, and in some cases the stock market if the bank is publicly traded. For larger national and international banks capital usually comes from stock held by mutual funds, investors, and other corporations. The source of the capital is important because it often effects the decisions being made by local bank management. If management at a small community bank is very conservative about how they lend money, it is likely it is because management has a vested ownership interest in the Bank and doesn’t want to experience losses that will negatively affect the bank’s capital and hence their personal net worth as owners. If management at another small community bank or regional bank is very aggressive in their lending, it is likely because they have outside capital and they know the better the return they get on that capital the more likely the value of the Bank will go up and the better they will be compensated in the process.
Knowing and understanding how and by whom a bank has been capitalized can give great insight to a borrower in how to deal with a lender. If the lender and management has an intertwined interest in a bank, then it is much more likely the Borrower needs to show that they can be trusted and work to form a solid long-term relationship with the lender. In some ways a bit of a courtship might need to happen when applying for a commercial loan, where the borrower spends some extra time getting to know bank management and getting them comfortable with the loan request. With these banks management is unlikely to make a decision without first getting fully comfortable with the transaction. Now, if the lender and management are focused on stock price and growth to meet outside investors and stock goals, the focus for the borrower needs to be on providing a profitable transaction with a reasonable level of risk and sufficient sophistication to make managing the borrower easy. Typically in growth situations banks want to deal with owners with experience and a track record who can provide profitable loan transactions with more to follow. Once the source of a bank’s capital is understood, it is then time to move onto how much capital the bank has.
The amount of capital in a bank has a direct effect on the amount of money a bank can lend. The FDIC has issued specific guidelines, which have increased over the past couple of years, defining the capital levels of Banks. Banks that are well capitalized (those with a capital ratio of 10% or higher) are deemed to have more than sufficient capital to cover their loans, and are highly likely to continue lending somewhat aggressively. Banks that are adequately capitalized (those with a capital ratio of 8% to 10%) are deemed to have sufficient capital to cover their existing loans and some excess capital to lend, but are much more likely to be conservative with the amount of new lending they do because they do not have a lot of excess capital should issues occur. Banks capitalized at a level below 8% are usually seen as being under some sort of duress, and are much less likely to continue doing new lending. Typically if they do new lending, it is going to be to existing quality customers, and they are going to avoid most new loan requests and almost all loan requests deemed to be higher risk (as I will further define below). Bank’s with capital ratios at 6% or under are likely to be under some sort of consent order with the FDIC or other regulatory action that somewhat restricts the amount and types of lending that they can do, and are unlikely to be doing much at all in the way of new lending as they are typically trying to conserve capital to get their ratios back up. In fact most banks with capital ratios below 6% are usually trying to push clients out of the bank to shrink the size of the bank and reduce the amount of loans they need capital for and hence get their ratios back up that way. Lastly, banks with capital ratios below 4% in most times and today below 2.5% are ripe for takeover, and are unlikely to be doing any lending at all.
By understanding the capital ratios of the banks a borrower is dealing with, the borrower can get a better idea of what type of response they can expect from their loan request. If their loan request has any risk to it at all, it is probably not likely a bank with a capital ratio under 10% can afford to consider that request. However, for a very secure loan request for a good borrower, a bank with a capital ratio even below 8% might be able to make that loan. If the banks capital ratio is below 6%, it is unlikely a bank is doing any lending at all, and it typically is not even worth applying for a loan with those institutions. It is important to note banks do not advertise when they have unhealthy capital ratios. So it is unlikely if you apply for a loan with a bank with an unhealthy capital ratio that they will tell you the reason they don’t want to make your loan is because they don’t have the capital to do so. Many banks with unhealthy capital ratios will still take applications and approve some of the highest quality loans either allowed by their consent order or that are very low risk, to preserve the appearance that they are healthy and still doing business, when in truth that really is not the case.
Banks need capital to cover their loans. Capital gets assigned to each loan made based on the risk associated with that loan. Banks usually have a grading system called a risk or loan grade system that they utilize to determine the risk associated with each loan. Loans deemed higher risk require substantially more capital reserved against them then loans at lower risk levels. So knowing and understanding the probable risk level of your next transaction and the requirements by which banks and bank examiners grade credits, can help a borrower position their loan to be more advantageous to a bank. Because having capital costs money, loans deemed to be higher risk cost more money to the Bank to make. A bank still may make those loans, but they usually demand a higher rate of interest to offset the additional capital cost and increased level of risk. By positioning loan requests so they are as low a risk as possible, which typically means having a strong primary repayment source (strong cash-flow), a solid secondary repayment source (guarantor support), and a strong final repayment source (collateral value), borrowers can encourage banks to make their loan and at the lowest rates possible. So it is good to position new loan requests so they meet all of the bank criteria of a good loan, and if they do not, to work on bringing credit enhancements to the table to make it so the loan does meet those requirements or you overcome the areas where the loan does not with other incentives.
The amount of capital needed for a loan is also effected by the collateral type. Loans on owner-occupied residential properties require the least amount of capital, whereas loans for speculative construction, land, and development require the most capital. In between these two extremes are investment real estate loans, which require the second highest level of capital, followed by owner-occupied commercial mortgage loans and business loans, which require slightly less capital then investment real estate loans. The least capital intensive loan outside of owner-occupied residential properties are apartment buildings, which require 50% of the capital of investment real estate loans. So it is much less likely that a bank with a lower level of capital is going to make an investment real estate loan or a construction loan then a bank well capitalized. Actually with some of the modifications the FDIC has made over the past several years, the amount of capital required for banks to make construction loans has increased substantially, greatly increasing the expense and risk for a bank in making those types of loans. So for a traditional banking institution to make certain higher risk loans such as construction loans, it really requires a solid loan request where the bank can get paid reasonably well and it confident the risk of a loss is very, very low. As can be seen, the type of collateral can play a crucial role in the lending decision for banks and many banks will not lend on certain types of collateral because of it.
In addition to needing capital to lend, commercial banks also need deposits to lend. Banks make their money by paying as little as possible for deposit accounts and then lending that money out for as much as they can to loan borrowers. Banks must maintain certain levels of deposits to loans. Depending on the type of institution and the institution’s own internal guidelines, most banks try to lend somewhere between 75% and 90% of the deposits they have. If a bank’s deposit ratio is already close to 90%, they are less likely to have the deposits necessary to do a bunch of additional lending. At that time a bank will typically go to the market and try to raise additional deposits. One way to do that is for a bank to focus it’s lending to clients that bring with them a strong deposit base. This often means lending on owner-occupied commercial properties and making business loans to operating companies where the bank can require all of the deposits from that operating company as part of approving the loan. Having deposits from its borrowers, especially if they are primarily demand deposits (checking, money market, and savings accounts), is very valuable to banks because they pay the borrower very little if anything for those deposits, they typically earns fees on the operating accounts, and then they get to lend the majority of those deposits back to their borrowers quite profitably.
Banks with high deposit ratios are likely to only do business with borrowers that can and will bring significant deposits to the bank to help support future loan growth, while banks with low deposit ratios are much less likely to worry about deposits and much more likely to just be concerned about loan volume because they have excess deposits they want to get a return on. Remember, banks pay for a majority of their deposits (money market, savings, certificate of deposit interest), so it can be quite expensive to have a low loan to deposit ratio. It can be quite advantageous for a borrower with high deposit balances to go to a bank with a high loan to deposit ratio, because the lender might be willing to give them a very attractive rate to get their business because having both their loans and deposits is much more valuable to that bank because they need those deposits to lend. However, a bank with plenty of lending capacity and not in need of the deposits is much less likely to pay extra for a loan relationship that includes a large deposit relationship. If it is a solid loan relationship they still might make the loan, but are less likely to give up a premium interest rate to do so. Again, this information can factor into dealing with each bank. However, if you don’t have much in deposits to offer, a Bank with a low loan to deposit ratio is likely to be a lot less worried about the deposits you can bring with as they need to deploy the excess deposits they already have.
As can be seen there are many factors behind the scenes at commercial banks that help to set the stage for how bank management reacts to different loan requests. Bank management is constantly reviewing their capital ratios, deposit ratios, risk grades of their current portfolio, and risk levels associated with different collateral types, and that is even before an individual credit decision can be made on new loans. So there are a lot of outside factors that go into each loan decision. Other concerns traditional bank lenders must be aware of and deal with in today’s market are as follows:
- Does the loan request meet the bank’s policy guidelines? If a loan request falls outside of a bank’s loan policy, they must have a really good reason for making that loan such as other offsetting benefits. If they don’t, then there is a much higher likelihood examiners will view that loan negatively, which could lead to a credit rating downgrade which would raise the capital requirements on that loan and increase the expense associated with that loan because capital costs money.
- Bank commercial loan portfolios are constantly under review, and are examined at least annually by regulators, and in most circumstances several times a year by external bank hired auditors as well. In each review examiners and auditors check the quality of the loans, which includes reviewing on-going financial reporting for commercial loans. The review also includes stressing collateral values and reviewing the financials to verify cash-flow is still sufficient to cover debt service. Because of this banks are hesitant to make loans to borrowers that they do not think prepare good and accurate financial reporting, or who are going to be difficult and not timely in providing their financial statements, tax returns, rent rolls, and other required documents to the bank annually. It is possible for loans with no updated financial information to be downgraded by examiners based on assumptions alone, which can greatly effect a bank’s capital ratios and hurt their profitability and ability to make more loans.
- Banks are required to put into their loan policy concentration limits on certain loan types, and must stay within those approved limits. Limits are usually set for special purpose loans (hotels, motels, gas stations, etc.), retail loans, apartment buildings, investment real estate and other loan types. A bank that is currently over-loaded with one type of loan such as retail properties might be very hesitant to make more loans to that asset type because their concentration risk is already too high and they don’t want to risk criticism from regulators. On a generalized basis the new guidance from the FDIC requests commercial banks not to lend more than 300% of their capital into retail centers. So that means if a bank has only $100 million in capital, they can only lend $300 million against retail properties. This is part of the reason many commercial lenders have backed away from making investment real estate loans in the current market.
- Banks are hesitant to make loans against many types of special-use properties such as hotels, gas stations, restaurants, etc. This is because over the years these types of assets have tended to struggle and values have fluctuated often. Typically if bank lenders are going to make loans on these types of assets, they are typically doing so at much lower advance rates then they would employ on other asset types and are charging a higher rate of interest because these loans are deemed more risky. Identifying this on the front-end and working to report as much cash-flow as possible is the key to getting these loans done.
- Due to new mandates from the FDIC, Bank’s must underwrite their loan requests not only at current market rates but must stress the interest rate used in case when a loan matures at a future date interest rates are higher. This is making it hard for many commercial investment properties to get financing because income is somewhat fixed based on leases. In many cases a property will underwrite based on exiting leases and an interest rate in today’s market, but might no longer underwrite when interest rates go up in the future.
- Bank’s are also feeling increased scrutiny from examiners on borrowers with whom they cannot provide a clear global cash-flow analysis. It is no longer sufficient for a Bank to complete a cash-flow analysis only on the subject investment property or business a bank is loaning against and agree to make that loan if the cash-flow for those entities alone is acceptable. Bank’s now need to take the time to analyze all of the real estate, business, and personal holdings of the borrower and guarantors, and prepare a global cash-flow analysis that evidences that all of the debt of the borrower can be supported by cash-flow and assets. This not only adds significant time and cost to the underwriting process, but also creates a great deal of hassle for commercial borrowers who often have to rely on credit staff with no direct understanding of their businesses to complete this analysis correctly. If a borrower with an existing loan cannot provide such an analysis or the analysis shows insufficient cash-flow, it is likely that borrower will be shown the door by the bank whether the subject loan is performing or not. This is because the Bank will likely see a risk grade downgrade in that loan, which will increase their capital costs for the loan making it more expensive. If a bank cannot get a good handle on a borrower’s global cash-flow before making a new loan, they are a lot less likely to make that loan on the front-end because they won’t want the loan downgraded later or have to worry about the time and cost of going through a complicated underwriting procedure with the borrower annually when it comes time to review that relationship. Proper underwriting and presentation of a borrower’s global cash-flow not only at the time of loan application but annually every year thereafter is very important to getting a loan approved and maintaining a healthy banking relationship going forward.
As can be seen, there are many things that get factored into the credit decisions made by commercial banks. And many of those items are constantly changing. Because of that commercial banks are constantly adjusting the types of loans they want, the interest rates they are paying on certain product types, and the type of deposit relationships they want. This can lead to quite a bit of stress for commercial borrowers, who one year feel very wanted by a bank only to find a year or two later the bank acts like it no longer cares about their business. It usually is not because the bank does not care, but it is usually because something has changed in the financial metrics of the bank and that borrower’s loan no longer fits within the bank’s metrics. Although this should provide little comfort for the borrower who is experiencing hard times or difficulties with their existing bank, understanding how banks work and how to position and mange your loan request (discussed in more detail in later chapters), will help eliminate and alleviate many of these concerns, and will allow a borrower to have a much more fluid relationship with their commercial lenders.
Commercial banks are not the only lenders at play in the commercial market place. Although commercial loan borrowers tend to come across these other lending sources much less often, and rarely when they are working on their own, it is still important to have some idea of what to expect when dealing with these other sources. Some of these sources are as follows:
- Fannie Mae & Freddie Mac – Not only are they two of the largest residential funding sources for single-family homes in the United States, but they also both have large lending programs for Multi-Family / Apartment buildings. The loans these organizations make on multi-family properties are funded similarly to the way they fund single-family home loans; they make a bunch of loans, package them together, and then sell them to the secondary mortgage market with a corporate guaranty, which is in essence a guaranty of the Federal Government. Because of the way they are guaranteed, there are very set underwriting criteria for these loans that include annual property repair reserves built into the loan budget based on a detailed review of the current health of each property lent against. The loans also must qualify under very set lending criteria. Lastly, not only do the borrowers have to qualify with Fannie Mae & Freddie Mac, but because the agencies licensed to make and package these loans have buy back requirements where they must by back all loans that default within a certain period of time, each originating lender also has their own underwriting criteria which is typically even tighter than Fannie Mae & Freddie Mac in order to avoid having loans go bad and get sold back to them. So it is possible to apply for a Fannie Mae loan at one agency and get denied but get approved somewhere else because the loan qualifies with Fannie Mae, but one lender still did not like the risk associated with it. These programs also have different lending criteria for different markets. In some states the loan to value is higher then in other states, all depending on market conditions. And although the legal minimum loan Fannie Mae will buy is $500,000, most of the agencies packaging these loans won’t do loans below $750,000 and many have minimum loan requirements of $1 million to $3 million. So it is important to research and understand the different options available and the different lenders out there dealing with Fannie Mae & Freddie Mac loans.
- HUD – HUD funds multi-family / apartment loans in much the same way Fannie Mae & Freddie Mac do with a government guaranty. However, HUD’s lending requirements are a lot less restrictive and they allow higher loan to values and extend out amortizations as long as thirty-five years with fixed interest rates usually lasting that long as well. Because of this their financing option is very attractive to most borrowers. However, for purchase transactions it often times does not work out as the process to get a property approved through HUD is a long and arduous one, and it typically takes close to nine-months to close a HUD transaction.
- Insurance Companies & Retirement Systems – Insurance Companies and Retirement Systems are lending their own money in order to get a fixed rate of return. Although they can get a fixed rate of return in the stock and other equity markets, in order to diversify their risk they also like to lend money out for certain commercial loan types as another source of a fixed income return. Because insurance companies are trying to build up long-term reserves and retirement systems are trying to provide returns to their clients safely, these organizations are usually looking to invest in relatively low risk loans. These loans are typically loans with loan to values at 65% or less (although on occasion and for certain property types sometimes they will lend at higher loan to values), and are usually made on low risk properties like those properties with national tenants or very strong regional or local tenants. Because of the cost involved in underwriting and approving these types of loans, these organizations often don’t look at requests with loan amounts below $2 million. However, often times they offer long-term fixed rates, sometimes as long as ten and even twenty years, which can make them very advantageous programs to borrowers with high enough loan amounts and safe enough investments.
- Conduits – Much like Fannie Mae & Freddie Mac, conduits make commercial loans and then package them and sell them off to the investment markets. However, unlike Fannie Mae & Freddie Mac these investments do not come with any sort of government guaranty. Because of this, conduits must find assets the investment community is interested in buying for a fixed rate return. For a while in the early 2000’s the investment market was buying just about all types of assets being offered by conduits. However, since the market crash conduits have really been struggling to find market participants willing to buy portfolios of commercial loans. Because of this really the only portfolios they have been able to sell are those at low loan to values such as 65% or less, and where there are very strong credit worthy tenants or extremely strong cash-flow. Conduits still offer a good alternative to individuals with solid commercial loan requests over the insurance companies, but this option is only available to a few qualified projects. Loan amounts must also typically be at least $2 million to even qualify.
- SBA Loans –The United States Small Business Administration (“SBA”) has loan programs geared to helping commercial loan borrowers. Almost all of the SBA programs are geared towards business loans directly to businesses or commercial mortgages on the real estate those borrowers operate out of. Because of this, the SBA is very centered on small to mid-sized businesses that are expanding, creating jobs, and that have strong enough metrics to make the risk of a default low. The SBA offers some guaranteed loans where the Bank underwrites, approves, and makes the loan but a large portion is guaranteed by the SBA and hence the Federal Government. So a borrower must still get a bank comfortable with the transaction, and the bank still has underlying risk to the unguaranteed portion should a default occur (usually the guaranteed amount of the loan does not exceed 80% of the loan amount, and in some cases is even less). Because of this banks are cautious about the types of government guaranteed loans they make, and just because there is a government guaranty in place, it does not mean the bank is going to get comfortable with the loan type. There are also many reporting requirements for banks involved in government guaranteed lending, which increase the expense of having those loans and the risk associated with those loans because if the bank fails to handle the loan properly, they can be at risk of losing their government guaranty. Because of this many banks choose not to participate in the guaranteed SBA lending programs.The other major type of SBA lending program is a debenture program, where the funding source works very similarly to a residential mortgage. A bank approves and makes a loan for 50% of the cost of a project, and the SBA makes the other 25% to 40% of the loan (for a total of between 75% and 90% of the lesser of cost or appraisal financing), which is then sold into the secondary market with other loans in the form of a debenture, which is guaranteed by the Federal Government. This debenture is bought by investors much like a Fannie Mae or Freddie Mac security is because it offers a twenty-year fixed rate return guaranteed by the Federal Government. The advantage to the Bank is that they have a loan at a relatively low loan to value. However, like with a guaranteed SBA loan, they still have the underlying risk of that asset and must work with the SBA should a default occur. So these loans are not without risk, and there are varying advance rates and lending criteria for different collateral and business types. These loans can also only be used for owner-occupied business properties, and although they do allow some cash for working capital, tenant improvements, and equipment, there are strict guidelines how that is handled. In addition to qualify for these loans a borrower has to be cautious about how they have their ownership structured, understand which banks are willing to lend on which type of assets even with an SBA loan in place, and understand the other approval and underwriting criteria of these loans to be sure they meet all of the requirements.
- USDA Loans – The United States Department of Agriculture (“USDA”) offers a guaranteed loan program that is very similar to the guaranteed loan program offered by the SBA and in essence allows banks to make a loan backed with a guaranty from the Federal Government (the amount of the guaranty varies depending on the size of the loan). The only difference with this program is that the loan must be made in a rural community and the loan type is not restricted to an operating business or owner-occupied real estate. The loan can also be used to fund the construction of retail centers, industrial parks, office buildings, and other uses. The catch is the project must be in a rural area where it is going to create jobs. The limits of the guaranty under the USDA program are much higher than under the SBA loan program, and many more projects qualify. But just because a project is in a rural community and is going to create jobs does not mean it will qualify for a USDA loan. There are still many additional underwriting guidelines the project must meet to qualify, so a commercial loan borrower has to be sure to position their request on the front-end to meet these guidelines. Also, because the loan is approved by the USDA within each individual State, the approval process varies quite a bit State to State and usually it takes longer to get a USDA loan approved then a SBA loan.
- Private Lenders – Capital for private lenders comes from many different sources. Sometimes private lenders are individuals making loans directly using their own capital. Sometimes they are private funds where a group went out to investors and raised capital specifically to lend. Under each situation, different criteria usually apply. When the funds come from private individuals often times those individuals have a say into how their funds are lent on each individual loan. Because of that these lenders and their investors are going to look at the overall quality of a project and try to make a decision about maximizing their investment safely. So it is important for a borrower to understand when working with this type of lender that the project has to make fundamental sense and they will need to take time to get the investor comfortable. However, there is often flexibility in terms because if an individual investor really wants to fund a project, they can tweak the terms by which they usually lend to get it done. When the private lender is using capital they have gone out and raised into a specific fund, typically there are underwriting requirements that were included in the criteria for which that money was raised. These requirements usually relate to the markets, collateral types, interest rates (rate of return for the investors), credit scores, and cash-flow requirements by which the managers of those funds can lend the money. Because of this only projects that meet those set criteria can even qualify for those programs. Understanding what type of program a borrower is dealing with is key to being sure the deal is structured to meet the funding available from that lender. Finding private lenders can be a challenge, and finding the right one can be even harder as each program can be very unique onto itself based on how the capital was raised.
All seven of these additional options (and please remember, this list is not all inclusive, but these are the main ones) have different capital sources and each have their own lending criteria that provide their own difficulties with underwriting and qualification. None of the options presented, including commercial banks, are necessarily easy to get a loan from, and all require time, patience, and figuring out the best way to position a loan request to meet each individual lenders qualifications and process. Like a comedian trying to entertain a crowd, as a borrower you need to know your audience, and be sure your loan request meets the needs and expectations of the lenders you are trying to appeal to; because if it does not, your chances of getting your financing approved get roped off the stage pretty quickly.