Commercial lending, for the most part is based on the value and performance of the commercial assets used as collateral. Because of the focus on the asset performance, many borrowers expect commercial loans to be non-recourse. Most borrowers are optimistic investors leaving much to chance. Most private lenders are bullish and use mathematical models to provide risk assessment. Loan originators are jammed up in the middle.Commercial Loan RIP
Private lenders determine risk just as banks do, with some exceptions. The private lending industry has additional obstacles as more and more people jump on the bandwagon to earn huge fees just by providing a referral. Just about anyone with a phone and a PC with internet access can refer deals to a commercial loan broker and expect a sizable commission. This adds burden to the loan and to the deal overall.
Getting a loan into underwriting by a private lender can be challenging as they all have their own criteria for evaluating risk. Some commercial brokers will provide much of the upfront work such as preparing the package and filtering bad deals. Others are no more than a conduit for providing documentation from the borrower. They try to justify their fees by participating in conference calls and prodding the lender for status updates. This micro-management of the file creates animosity between the brokers in the chain and may eventually kill the deal.
Is your deal bullet-proof? If you have any of the following issues your project may be facing insurmountable obstacles. While it’s true that some issues can be overcome at a cost, others are just poison. Hopefully, this article will help you to evaluate your deals and avoid some headaches.
# 10 – Property Issues
Contrary to popular belief private lenders do not like distressed properties and REOs. The mere fact that a property is distressed means there may be issues with title, legal issues, tenant issues, local economy, and ability to service debt. Remember, the banks want to dump these assets. That should be a clue. Subtract 5 for each of these issues, add 10 if the property title is clean and performing.
# 9 – Borrower Investment
Some commercial brokers think they sound experienced by using the term “skin in the game.” Frankly, commercial lending is no game and the borrower’s equity can be evaluated in many ways, depending on the history of the property and the number of owners. On the other hand, if an investor is trying to purchase a property with no cash, he/she is just a dreamer. Subtract 25 for this scenario. Add 5 if the borrower has 5% invested, add 10 if the borrower has 10%, and so on.
# 8 – Management Experience
I was contacted by a pro football player last year who was advised by a fellow player to get into commercial real estate investments. This makes some sense, since an injury can end a career for pro athletes. So he asked me how to buy an apartment complex. You need experience. How does one gain experience? Find an experienced partner. Subtract 10 for no experience.
# 7 – Financial Strength of Principle
Net worth and liquidity are on every lender’s intake form. So why do borrowers and their referral sources ignore the simple facts? Most commercial loans are full recourse. This is typically based on the cash invested in the property and the net worth of the borrower. Borrower credit scores are evaluated just the same as home buyers. Credit scores affect interest rates. If the borrower liquidity is less than 5% subtract 75. If the borrower’s net worth is less than 50% of the loan amount, subtract 25.
# 6 – Broker Chains
The more brokers in the chain, the less likely any lender will consider the loan. There are exceptions – Large attractive deals where the lender stands to make a bundle. They will demand direct communication with the borrower. Two brokers is an acceptable situation. Subtract 10 for each additional broker.
# 5 – Upfront Broker Fees
Brokers do not risk anything by working with borrowers that shop deals. If a broker charges a fee it usually means they are not confident that they can provide a lender. The lender is the one at risk. For that reason, many direct lenders will charge due-diligence fees and a commitment fee up front. These fees are typically credited at closing. The whole idea is to protect the lender from a borrower who shops the loan. Subtract 15 if the broker charges upfront fees.
# 4 – Exit Strategy
Borrowers with poor or no exit strategy are not prepared and show a lack of experience and business expertise. The Lender needs to know how he will get out of the deal. Subtract 10 for poor or no exit strategy.
# 3 – Loan Shopping
Loan shopping at the very least shows deceit on the part of the broker or borrower. At best it shows that the borrower has poor character and no consideration for the effort and cost expended by the lender and brokers. How would you react if you spent 20 or more hours finding a lender, preparing information, evaluating documents, and making a case for your client, only to have them work with someone else? Most borrowers will not sign exclusive agreements. The fact is most brokers provide little value and have not earned their clients’ trust. Subtract 30 if the loan is being shopped.
# 2 – Excessive Fees
This occurs when there are too many brokers in the chain and they are not working in the borrower’s interest. Overcharging fees is a poor reflection on a broker’s character as their motive is based on money, rather than providing a service. You can’t tell other brokers what to charge, but you can certainly refuse to work with them. Subtract 10 for each point, if brokers are charging more than one point each.
# 1 – Debt Service Coverage Ratio (DSCR)
How many times have you heard borrowers say, “The net income on my tax returns is lower than my actual net” …really. Just because they send information all tidy on a spreadsheet does not mean that the income will actually service the loan. The underwriter will verify all this. Most lenders want 1.25 DSCR or above. Check the expenses and ask questions. Subtract 90 if the DSCR is below 1.25, add 75 if above.
So how did you score? Anything above 75 is promising. Below that, you may want to rethink your situation.