What do a commercial mortgage loan and a residential home loan have in common? They can both disappear like Houdini if you are a high-risk borrower. Read on to learn more about what makes a borrower appear risky to a commercial lender and how you can still get funding if you have credit problems.
What is a high-risk borrower?
A high-risk borrower is someone who a lender would consider likely to default on a commercial mortgage loan. The prospect of a commercial mortgage loan default is what keeps most commercial loan officers up at night. Why? Because most commercial property loans are non-recourse, meaning that if a borrower defaults, the lender can only take back the property used as collateral for the mortgage and cannot go after the borrower’s other assets. Although the lender can sell the property, the lender must write off the difference if the proceeds don’t cover the loan balance.
What is commercial credit risk analysis?
Commercial credit analysis is the investigation of a borrower’s ability to meet its financial obligations. Commercial lenders are in the business of mitigating the risk associated with your loan. A commercial mortgage lender needs confidence that you and your partners have the credentials, education, real estate expertise, and cash flow to pay back your loan. Your lender will probe your reputation, your credit history, your credit score, your cash flow, and the value of the collateral pledged as security for the loan.
Credit analysis by a lender generally breaks down into two major categories:
- The borrower’s qualifications and financial condition to take on the loan, and
- The cash flow of the borrower’s business and collateral to repay the loan.
What is 5c credit analysis?
Lenders review five key factors to predict the likelihood a borrower might default on a loan. Known as the “Five C’s” of credit, the factors include Character, Capacity, Capital, Collateral, and Conditions.
Character – Commercial lenders want to know that you and your business partners are financially responsible. Financially responsible means not insolvent. A lender may request CPA-audited statements of your business and that you disclose any outstanding defaults, liens, convictions, pending lawsuits, or evidence of “breach of trust” actions. You may need to prove that you are authorized to sign the loan documents and that your business entity legally exists and is in good standing. The lender will review personal credit scores and a business credit report to confirm that you paid past loans on time. Recent bankruptcies, deeds-in-lieu of foreclosure, or a current conviction or pending lawsuit are red flags to a lender.
Capacity – Capacity focuses on your business’s ability to service the loan with adequate cash flow. Your lender will review your business expenses and debts, including that of all commercial real estate you own. Most lenders calculate a Debt-Service Coverage Ratio (DSCR) to measure the cash flow available from the property you are financing to pay the current debt obligations of the proposed loan. The formula refers to the Net Operating Income (or free cash flow) divided by Total Debt Service (or annual principal and interest payments). The ratio measures how many times free cash flow can cover yearly debt service. Lenders perceive a low DSCR of ≤ 1.0X as high risk.
Capital – Lenders will analyze the amount of capital or business equity for a commercial loan application. Business equity is sometimes referred to as “skin in the game” and tells the lender how much of a borrower’s own money is involved. Most commercial mortgage lenders calculate a Loan-to-Value (“LTV”) ratio on the property securing your loan. The LTV ratio divides the loan amount by its appraised value or its purchase price. For example, if you buy an apartment building for $2.0 million and borrow $1.3 million, your LTV ratio is 65% ($1,300,000/$2,000,000 = 65%). Your equity in the transaction –or “skin the game” –is 35% ($700,000). Commercial real estate LTV ratios generally range from 65% – 75%. Lenders consider loans with higher LTVs to be higher risk and may charge a greater interest rate or require additional collateral at the upper end of the range.
Collateral – Commercial mortgage loans are typically secured loans. The lender has a legal claim to the property you are financing should you default on their loan: the better the collateral, the less risky the transaction. Before a commercial lender approves your loan, you will be asked to provide two or three years of annual operating history of the property, showing gross income, vacancy losses, operating expenses, and taxes. A lender will generally visit the property, evaluate the bricks and mortar, talk with the tenants, and assess the market. Lenders consider properties with a poor or limited operating history, building code violations, environmental problems, or a past foreclosure to be higher-risk collateral.
Conditions – The loan conditions refer to the interest rate, the loan amount, and how a borrower intends to use the money. It also considers the economy, the real estate market, and industry concentrations that may affect the collateral. Unstable industries like restaurants, casinos, or golf courses are high-risk.
Are you a high-risk borrower? Take the Quiz.
- Below are some of the questions you may encounter during lender due diligence. If you answer “Yes” to many or most of these questions, you may be considered high-risk.
- Have you ever had criminal charges brought against you?
- Have you, or any entity in which you were an investor, ever filed for bankruptcy?
- If you have partners with 25% ownership or more in the borrowing entity, have they ever declared bankruptcy?
- Do you or your partners have low credit scores?
- Have you or any property in which you invested been foreclosed upon, subject to a loan workout or deed-in-lieu of foreclosure?
- Has the property (collateral) ever been conveyed by deed-in-lieu of foreclosure?
- Has the property (collateral) ever been the subject of any building code, environmental, health, or licensing violation?
- Are you new to owning and managing commercial real estate?
- Are you borrowing more than 75% Loan-to-Value?
- Does the property or borrower have less than two years of operating history?
- Do you have high debt on other properties you own?
Can you still get a commercial loan if you are a higher-risk borrower?
If you answered “Yes” to many of the questions above, don’t despair. There are multiple ways to boost your chances of getting approved for a commercial loan, such as using loan structure, agreeing to pay a higher interest rate, or pledging additional collateral. A commercial mortgage broker can help overcome credit or structure hurdles to mitigate the risk of your transaction and secure a competitive interest rate for your loan. Don’t go it alone.
Summary
A high-risk borrower is someone who a lender would consider likely to default on a commercial mortgage loan. Commercial credit analysis is the investigation of a borrower’s ability to meet its financial obligations. Lenders review five key factors to predict the likelihood a borrower might default on a loan. Known as the “Five C’s” of credit, the factors include Character, Capacity, Capital, Collateral, and Conditions. Consult your commercial mortgage broker to help overcome credit or structure hurdles of your transaction and get your loan approved.
