Part 1 – What Do Banks Really Care About When Looking At Your Loan? (Sep.2, 2014)
Part 2 – How Does a Commercial Loan Differ From a Residential Loan? (April 14, 2016)
Thinking of applying for financing, but not sure if you’ve got what it takes to qualify?
One of the most important factors banks use to identify suitable borrowers is the LEVEL OF RISK in lending to that particular investor. And although you can’t change your financial history in 5 minutes, being aware of what constitutes risk, and how to control it, can give you the ammunition you need to present a compelling case to the bank.
What The Banks Really Care About When Looking At Your Loan?
Banks are expected to:
- identify risk,
- measure risk,
- monitor risk and
- control risk
… in order to maintain the financial integrity of their institution.
While there are numerous risk factors that the bank uses to evaluate your property, there are 6 risk factors that banks identify when examining your loan eligibility.
Unbuilt properties are especially risky propositions for banks. Because they are in the process of construction, not only is there no history of profitability, but there isn’t even a guarantee that construction will be finished, and on time.
And although there are numerous reasons for why delays take place, for example material or labor shortages, or substandard work that needs to be redone, the result is the same: a significant increase in costs.
Of course, the costs of construction can also cause delays, due to the inability to pay for the unexpected difference in costs. It’s not unusual, for instance, for sudden increases in material, or delays caused by inclement weather, to interfere with the best laid plans of a developer.
Interestingly enough however, existing properties that are in the process of being renovated are even more susceptible than new developments to this risk. Sometimes this is due to renovation uncovering a feature of the building that needs to be fixed, or completely replaced.
Beware Of Leases That Are Close To Expiration
Market conditions are another risk factor that are generally not under the control of the developer or the investor, although thorough due diligence can uncover some issues.
There are several market factors that are like a red flag to bankers watching out for things that can go wrong.
One of the most common signs that a profit is entering the red zone are tenants who allow their leases to EXPIRE.
Tenants who don’t renew do so for a number of reasons:
- Bad economic conditions.
- Too many businesses of the same time in a small area.
- Or simply a weakening credit score, as in the case of franchises.
Bank managers worry that a higher than normal vacancy rate means less profit, but they also worry that it’s a symptom of a deeper problem with the property. If so, then the owner might also be faced with tenants who ask to reduce their space in order to save on expenses, or worse, who go out of business completely, breaking the lease altogether.
Generally short-term leases are more vulnerable to fluctuations in the market. For example, if standard rents for that market go down, a tenant with a short-term lease has the option, at the end of his lease, of forcing the owner to renew the lease at a lower rate. Although it reduces profits, many owners reluctantly give in, since the cost and effort in finding a new tenant, as well as the cost of a vacant space, aren’t worth it.
For this reason, if you are considering getting financing for a commercial property whose tenant leases are close to expiration, you should consider offering tenants a significant incentive in order to sign a new lease.
These incentives might include an upgraded space, a cash discount, or even a reduction in the rent rate for the first year of the lease. This way, you can at least show the lender that despite the leases being close to expiration, profits will still remain pretty much the same.
The truth is that lenders are just as interested as you are in making sure your property sees a profit. And although it may seem as if they’re nitpicking, or out simply to make things harder for you – they’re not.
Often, simply asking what are the best things you can do to prove you deserve the loan, will, as well as attempting to comply with requests in a timely and pleasant manner, can go a long way to showing that you’re the type of investor they’d like to work with.
How Does a Commercial Loan Differ From a Residential Loan?
First, you will likely find higher rates than you’d get with a residential loan, as well as shorter lengths of time before the loan is due, with balloon payments often due after 5 or 7 years.
First of all, the amount of time a loan comes due will often be shorter, with balloon payments due after five to seven years. Below are some other important differences.
Debt to Income: Plays less of a role than in residential loans. Although banks will reference this number, banks tend to focus on the property’s potential cash flow, and the amount of experience an investor has had with previous holdings.
If you have less than stellar credit, you can compensate by either taking on a partner or making sure you present yourself as a professional investor. Creating a written business plan and being thoroughly versed in all aspects of the property, ensuring you’ll be able to answer any questions that may arise about the deal- will go a long way towards presenting yourself as a serious investor worth lending to.
Credit Score: Your credit score shows how well you are able to handle money, and as a result, is a critical component for commercial deals under $3 million. Most lenders will want you to have a minimum of 660, while a number of 720 or higher will raise your chances of receiving the loan.
In addition to your credit score, banks will also take a close look at your credit quality.
There should be no open tax liens or judgments, no foreclosures within the last three years, and no bankruptcies within the last seven years.
Sometimes, depending on the size of the deal, a high personal net worth can help you get a loan where a property would be deemed too high risk. If you don’t have a high personal worth, then your best bet is to stick to creditworthy tenants like Walgreen’s, Auto Depot, or another triple net property.
Loan to Value: Loan to value is the ratio of the total amount of the loan as compared to the appraised value of the property. For example, if the you requested a loan of $2,000,000 for a property that was appraised at $2,250,000, then the LTV would be 88%. Keep in mind that banks don’t always agree with a property’s appraised value, and may decrease the appraised amount, thereby raising the LTV.
The actual LTV required will differ from bank to bank; that’s because this number will depend on their portfolio concentrations and their strategy for growth. LTV will also vary depending on the property type.
Undeveloped land, for instance, is considered riskier than a fully occupied retail mall, and hence will have a higher LTV. In general, however, the bank will look for an LTV no higher than 70-80% so they can have a sufficient amount of equity in the property in case you enter foreclosure and the property needs to be re-sold.
The LTV also determines how much you will need to put down on a commercial property. So if a property has an LTV of 70%, you will need to put 30% down, and the bank will provide the remaining 70%.
Debt Service Coverage Ratio: Debt service coverage ratio is calculated by dividing the NOI by the total debt payment. The total debt payment includes both the principal and the interest of your loan payment. Commercial lenders use the DSCR to determine how much cash flow there will be on the property in order to ensure there will enough money to repay the loan.