Credit Marker Monday
by Extensia Financial, a member of the Avana Family of Companies
Extensia Financial is very proud to present our 10-part series, Credit Marker Monday, which features expert guidance on assessing credit risk from Matt Hunt, Payal Bhatia, Sadaf Gill, Chrystelle Mae Quioyo, and John Schroeder!
Tip #1: Liquidity by Matt Hunt
Understanding borrower liquidity is key to assessing the risk of any lending transaction. Liquidity is a measurement of how easily assets can be converted to cash. Cash is the most liquid asset. Marketable securities are also highly liquid; however, when evaluating marketable securities, you need to consider that their value can be volatile and there may be capital gains taxes associated with converting them to cash. This is true of other assets as well. It is important to understand the price volatility, time necessary to market and costs of converting assets to cash (i.e. capital gains taxes, commissions, early retirement account withdrawal fees and taxes, etc.) when assessing an applicant’s net worth.
While loans are generally repaid with recurring cash flows, the liquidity a borrower has relative to the amount they are borrowing is also relevant. Borrowers who hold significant liquidity can outlast temporary cash flow disruptions. Those borrowers who held higher levels of liquidity have been able to continue making loan payments while also covering their other expenses while their revenues have been negatively impacted due to the business disruptions caused by the current pandemic. Those who had liquidity have been better able to weather the storm.
Tip #2: Market Conditions by Payal Bhatia
Local and national market trends have direct impact on business cash flows, property values and capitalization rates. A global pandemic, ensuing lockdowns and a national recession of course have an almost universal affect. However, outside of these obvious trends, we need to understand the local economy and market drivers for the specific market and sub-market one is lending in.
Whether the local economy is diversified should be a key concern. If the local economy is largely driven by one industry what impact will a weakening in that industry cause your Borrower? Researching whether large/ Fortune 500 type firms are planning investments in your market is a great way to assess market sentiment. The demographics, income levels and unemployment rates are all factors to consider as they influence real estate prices. A growing population, healthy income levels and low unemployment rates are signs of a vibrant local economy. Another key consideration should be local competition. A high concentration or oversupply of a certain property type will drive values down. Although no business is completely immune to market forces, a good practice to insulate the business and avoid value erosion of real estate is collecting reserves for CapEx, taxes and insurance.
Tip #3: Occupancy Rate
Occupancy is an important factor when measuring credit risk. Recurring cash flows, which are generally the primary source of loan repayment, are largely dependent on a property’s occupancy rate. It is important to understand the breakeven occupancy, which is the minimum occupancy rate that a property can be leased at to cover all expenses and debt service obligations, when determining if there is enough cushion to protect against volatility in occupancy.
It is also crucial to compare the underwritten property’s occupancy rate to similar properties in the market. Market occupancy rates are a key indicator of market strength and demand for space in the area and can be used to estimate vacancy loss, particularly when a property’s occupancy rate is higher than the market occupancy rate. Comparing a property’s occupancy rate to the market occupancy rate can show how a property is performing relative to comparable properties. A low occupancy rate relative to the market occupancy rate could be a sign that the property is poorly managed or that there are issues with the property.
Tip #4: Debt Service Coverage Ratio by John Schroeder
Debt service coverage ratio is a strong indicator of the ability for a property or business to repay its debt obligations. The ratio is calculated by dividing the borrower’s cash flow available to service debt by its annual debt payments.
Understanding the recurring cash flow for a business or property is essential as one-time events can cause the debt service coverage ratio to rise and fall from year to year and cloud the true performance of the property or business. An example of a one-time event could be an expense, such as a new roof, that could have been capitalized but was instead expensed on the income statement. Since it can be reasonably assumed that a new roof will not be required in the near future, this expense could be excluded from the debt service coverage calculation.
Another debt service coverage ratio that is important is the Global Debt Service Coverage Ratio. This ratio includes the cash flows and debt service obligations of the property/business, the guarantor(s) and possibly other affiliated companies on a combined basis. This ratio will indicate how they are performing on a combined basis and is an indication of whether the guarantors provide additional support.
Tip #5: Loan to Value by Sadaf Gill
The Loan-to-value (LTV) ratio is a relative number that suggests the risk lenders are taking relative to the collateral on a secured loan. It measures the relationship between the loan amount and the market value of the asset securing the loan. A high LTV ratio is riskier to the lender, therefore loans with higher LTVs typically come with higher interest rates.
The LTV ratio is calculated by dividing the loan amount by the value of the asset, and is expressed as a percentage. Lenders place great importance on the LTV ratio during the credit evaluation and approval process. However, the LTV of the asset can be calculated at any time during the life of the loan by dividing the amount owed on the loan by the asset’s current market value.
As the loan is repaid, the amount owed to the lender decreases, which results in a lower LTV, assuming the collateral value is steady. Alternatively, increases in the value of the property over time will also reduce the LTV. However, if the property value drops the LTV will go up, thereby increasing the risk to the lender.
Tip #6: Guarantor Credit Score by Chrystelle Mae Quioyo
A key metric we focus on when evaluating a loan application is the credit score of the individuals behind the transaction. Credit scores predict an individual’s willingness to repay debts based on past and current use of credit.
According to Experian, scores range from a low of 300 to a high of 850, with an average of 711 as of 12/20. In our policy, the minimum acceptable FICO score is 650, but our loan applicants generally have FICO scores above 720.
Top factors affecting credit scores include payment history, credit utilization, credit history length, credit mix and new credit. Factors that hurt an individual’s credit score include missing payments, using too much available credit, applying for a lot of credit in a short time, and defaulting on accounts.
We use a tri-merge personal credit report in our analysis, which contains FICO scores and credit histories compiled from the three main credit bureaus.
Credit reports also include a detailed credit history outlining creditor, account type, balance, terms, status, days late, etc. Derogatory records such as charge-offs, disputes, bankruptcy and public records are also disclosed in a credit report. These factors help in form evaluating loan applications.
Tip #7: Deferred Maintenance by Matt Hunt
During the underwriting process, it is important to understand the physical condition of real estate collateral to determine whether the building and its systems are functional and to assess what repairs are immediately necessary, as well as those that are likely needed in the future. It is particularly important to determine whether the foundation, structure, roof and mechanical systems are in need of repair. Those items can be costly, and their failure can cause a significant reduction in the collateral’s value.
Lenders generally order a Property Condition Assessment (PCA) to determine a property’s condition. The PCA is typically done by a third-party expert with a background in construction and building systems. The PCA will outline the condition of the various building systems, point out areas needing immediate repair, list repairs that are likely to be needed soon and estimate the cost of both immediate and upcoming repairs. That way, the lender can ensure that the repair items are addressed prior to closing or ensure funds are reserved for upcoming repairs.
In addition, annual inspections are typically performed to alert the lender to any new problems and to ensure the borrower continues to maintain the property in an acceptable condition.
Tip #8: Sponsor Experience by Payal Bhatia
The educational, professional experience and business background of the principals of the borrowing entity are key considerations when assessing credit risk. This is especially true when providing business loans and lending on special purpose real estate – properties that are built for a particular industry, such as assisted living, hospitality, nursing homes, schools, etc. Operating these businesses requires in-depth knowledge of the industry. Thus, lenders look for a track record of stabilizing and operating similar assets, particularly through tough economic periods.
Considering the qualifications of the management team is essential. For small businesses that are driven by the founder, it is important to gage whether a team member can continue to operate the business in case of an unforeseen circumstance.
Business owners sometimes engage a third-party management company that specializes in that asset type. Management companies bring the benefit of industry best practices. They also provide staffing; hence, the business owner may not need to develop a full team in-house. With management companies, lenders look for a good portfolio of similar properties. Additionally, reviewing financials of other properties managed by the same company can provide great insight.
Tip #9: Geography by Sadaf Gill
What is the most important thing to consider when buying real estate? “Location! Location! Location!” As cliché as it sounds, it is a crucial factor to consider when deciding to invest in a property. Therefore, it is equally important for a lender to take into consideration when evaluating a loan secured by commercial real estate.
An underwriter must understand the source and sustainability of demand drivers for the local market. Proximity to amenities, green space, scenic views, and the neighborhood’s status factor prominently into residential property valuations; while proximity to customers, markets, warehouses, transport hubs, freeways, and tax-exempt areas play an important role in commercial property values.
It is also critical to understand the demographics of a market area. Areas with population and job growth will have increased demand for real estate, causing property values to appreciate over time. Further, a well-diversified economic base minimizes the risk of real estate value shocks that can be caused by the loss of a single large employer or industry in the market. Properties in economically diverse communities with growing populations will fare better than those located in rural communities or with a declining population trend.
Tip #10: Lease Rollover by John
Lease rollover affects many loan requests in commercial real estate lending. On many occasions the loan term could be longer than the remaining lease term for the tenants located within the collateral property. Multi-family properties tend to have lease terms of a year or less. Office leases can also be shorter in term, anywhere from one to five years. Retail leases can be for five to ten years or more, depending on the tenant.
A few important factors an underwriter should focus on while assessing the risk of a loan request with lease rollover are:
- Length of time the tenant has occupied the space
- Options to extend the lease from the original lease or amendments to the original lease
- Tenant’s industry
- Market Conditions – lease rates and market vacancy
- Location and condition of the property
- Amenities provided by the property
This information can help gage the likelihood of a tenant renewing their lease and also help determine the likelihood that a new tenant, at or near the same rental rate, could be found if a space is vacated during the loan term, ensuring that the primary source of repayment continues.
Credit is more than a number. As we’ve discussed, determining good credit involves considering many aspects such as liquidity, market conditions, occupancy rate, DSCR, LTV, guarantor credit score, deferred maintenance, sponsor experience, geography, and lease rollover considerations. By including these critical components you can ensure that you are making the best credit choices for you, your business, and your investors.
Should you find yourself needing more information on these ten tips or anything else credit related, please contact Matt Hunt at firstname.lastname@example.org.