An insider’s view of a commercial lender’s concerns and how to satisfy them.
Knowing what your lender wants in a borrower will help you obtain the financing you need under advantageous terms to achieve your business objectives.
Respect the people that represent your lender.
I was in-house legal counsel at a real estate investment company where the CEO was a well-known relationship person with a broad, strong network. The company had several loans with the same lender, and the CEO was adamant we would timely report financial results every quarter as required under our loan documents. At the time, I didn’t understand why he was so adamant until he explained: “A person with our lender manages our account, and every quarter that person sits in a meeting and is asked which of the borrowers he or she manages didn’t report financials. I don’t want our relationship manager to be on somebody’s bad list because we didn’t provide our reports.” I never realized how important this advice was until I went to work for a commercial lender.
We often think of banks and other financial institutions as large, monolithic corporations devoid of personality or people. The truth is, these companies are run by people (unless you’re reading this after artificial intelligence takes over the banking system). These people make decisions about your loan, and the quality of your relationship with them will affect how they handle your loan and your requests. Hopefully, you will always be able to make your payments and comply with the covenants and conditions of your loan. However, if you ever stumble, you may be at the mercy of the people that manage your loan. The need for kindness, courtesy, and respect goes without saying, but on top of that, you should always make sure you timely comply with the requirements and requests coming from your lender and always keep them aware of issues that may affect your ability to comply with your loan documents. Maintaining a good relationship with these people will go a long way if you ever have to ask them for assistance in working out an issue you have with your loan.
Know your loan documents and what’s in them.
I had a partner who used to say the minute you sign a construction loan agreement you are in default. His joke was not far from the truth.
There is an enormous number of terms, covenants, and conditions in a 60- to 100-page set of loan documents. Unfortunately, many borrowers rely upon statements and discussions they had with their loan officers without reviewing their final loan documents before signing to confirm they understand the terms and conditions. In some cases, even their loan officers may not have reviewed the documents to ensure they meet the parties’ intent. It is imperative that you carefully review your loan documents and understand your loan obligations. No one wants to be in a position where they’ve signed loan documents and suddenly find they are in default of a term or condition that they didn’t expect. Believe it or not, this happens frequently.
Certain legal principles state, in essence, that regardless of what a party negotiated prior to executing a final contract, once the contract is signed, any prior negotiations that conflict with the final written agreement are null and void. Of course, there are counterarguments to this principle, but no one wants to rely upon a workaround or fancy lawyer tricks to get out of trouble. Therefore, it is imperative that you receive the final version of your loan documents well in advance of signing and carefully review them so you understand the borrower’s obligations. You don’t have to be a lawyer to review loan documents; it’s just tedious work that no one likes to do (except lawyers!). If you are represented by counsel, make sure that you give your attorney your letter of intent, commitment letter, or other instructions telling them exactly what you are expecting in your loan documents, and have your attorney confirm that your expectations have been met.
Finally, make a list of obligations that you must comply with (look for terms like “borrower shall”) and when, such as meeting certain financial covenants, reporting financial information, and maintaining collateral. It’s common to hear a defaulted borrower state: “I had no idea that was in my loan” or “That isn’t what we agreed to before we signed the loan documents.” These protests fail in court. Once you sign your loan documents, it’s final, and you must comply with those documents or risk being in default, paying default interest, or worse, losing your collateral in a foreclosure and seeing your guarantors sued.
Preserve your collateral, income, and assets; only give what you must.
Because repayment is your lender’s primary goal, it is very careful to ensure it has multiple sources of repayment: either cash-flowing collateral (think rental property), guarantors with high liquidity or net worth, or multiple pieces of collateral with low loan-to-value ratios that it can easily foreclose on to pay off the loan. The better your sources of repayment, the more likely your loan will be approved and with better terms.
Your lender likes monogamy; it wants to be your only one and it wants to be your first. It wants all you can give, and it doesn’t want to compete with other lenders, but this may not be realistic.
Your lender wants all the collateral and guarantors you are willing to give in support of your loan and doesn’t want to compete with other creditors. If its borrower gets into financial difficulty, your lender wants to be paid first before other creditors and wants the ability to easily foreclose on its collateral. Bankruptcy can be a nightmare for a lender, but it is much easier if it is a secured creditor (it can take its collateral and not have to fight with unsecured creditors) or if it is the only creditor and doesn’t have to fight with anyone. Your lender also wants to be first; if it has “priority” of lien position, it gets paid first. This usually means it is the first to obtain a lien in the collateral and file or record its lien in the appropriate public records.
Your lender also doesn’t want a borrower that is so leveraged it has difficulty making its loan payments, which is the purpose of financial covenants and providing financial reporting to test those covenants. In addition, your lender must report the financial condition of its loan portfolio to regulators to determine its capital reserve requirements. Poor loan grades mean higher reserves, which cost money—even if borrowers are making payments.
What’s a borrower to do? First, before granting all your property (both real estate and personal) as collateral to a single lender, make sure it’s what the lender really wants and needs. For example, a real estate lender may only be truly interested in the real estate collateral but ask for all personal property as well (the old “belt and suspenders approach”), meaning not only does the lender have the real estate as collateral, it also has furniture, equipment, and accounts receivable not part of the real estate. Personal property collateral to a real estate lender may be a hindrance because it has to be removed from the realty and sold at pennies on the dollar (think used restaurant equipment). Second, a smart borrower segregates its assets and preserves each category of asset for the type of lender that truly requires that particular asset as collateral. Third, some real estate lenders may require the borrower to be a single asset entity (special purpose entity or SPE) in which the borrower will only own the real estate collateral and nothing else, so the lender doesn’t have to compete with other creditors for the asset.
Case Study: A borrower that owns a manufacturing facility (the real estate and business operation on it) may give a real estate lender a lien on all the real estate and personal property it owns. That leaves no collateral for other types of financing. Instead, it can pledge only the real estate as collateral to a real estate lender, its equipment to an equipment financier or seller, its vehicles to an auto lender, its accounts receivable to a factor (lender), and even ownership shares in the borrowing entity to a mezzanine lender. So long as the borrower isn’t overly leveraged, this is completely acceptable and opens up several financing opportunities.
The five C’s of credit.
No discussion on a lender’s desires is complete without addressing the five C’s of credit: character, capacity, capital, collateral, and conditions. The five C’s are the basic criteria lenders use to gauge an applicant’s (both borrower and any guarantor) creditworthiness for a particular loan. Your best chance of loan approval with preferred terms depends upon how you maximize your five C’s.
- Character: More than just credit history or FICO score, it includes the applicant’s history of paying loans as agreed, their honesty, integrity, experience, and education. In some cases, a lender may consider whether the applicant has a history of litigation, especially with creditors. It goes without saying, personal bankruptcy or lawsuits with creditors are not good signs of character to a lender.
- Capacity: The applicant’s ability to pay the loan back (the primary source of repayment) based on its cash flow to cover its debt payments (its debt-to-income ratio or debt service covenant ratio (DSCR)). This ratio is the operating income available to make debt payments (e.g., interest, principal, and lease payments). The higher this ratio is, the easier it is to obtain a loan, but the required ratio will vary based on the business activity. The DSCR for a real estate investment may be much lower than for an operating business.
- Capital: The amount of money an applicant has. This includes the applicant’s investment in the enterprise subject to the loan (having “skin in the game”), as well as their liquidity and/or net worth available to make the loan payments should the borrower’s DSCR deteriorate. It also assesses any guarantor deemed a secondary source of repayment.
- Collateral: An asset pledged as security for the loan; the lender may foreclose on the collateral if the borrower defaults. The loan-to-value of collateral (LTV ratio) determines how secure the lender’s collateral is. In addition, cash-flowing collateral may be preferred. Consider a construction loan vs. a fully tenanted apartment complex. Should the lender foreclose before construction completion, it must spend money to complete construction and stabilize the property. In contrast, a cash-flowing apartment complex would be easier to sell, significantly mitigating the lender’s risk.
- Conditions: The terms of the loan itself and the general market or economic conditions. What type of loan terms (rate, loan amount, terms) will the lender require based upon the economy in general? In bad economies, lenders demand the most stringent terms. However, in good economies, lenders frequently compete with each other and are willing to ease up on conditions.
Most negotiators have a laser focus on their own objectives but are ambivalent about their opponent’s needs. The best negotiators understand their opponent’s objectives and how they can achieve their own goals by satisfying their opponent’s needs. Knowing what your lender is looking for will allow you to maximize your position to obtain the most favorable financing available.