Default: The Kryptonite of Lending & How Underwriting, Credit Analysis, Risks Management are Used to Avoid It – Borrower Be Aware!!!

Every lending institution has a lending process to evaluate a sponsor and its ability to lend. This process can be broken down into four categories: (i) preliminary analysis, (ii) repayment sources, (iii) packaging the loan, and (iv) closing the loan. Under each category there are many other processes that occur from policies, regulatory framework, legal, compliance, examination, asset management, servicing, risks management, etc. Interestingly, with all these critical aspects that are utilized to provide loans to a borrower, the three most vital elements are: underwriting, credit analysis and risk management. The above mentioned are the holy grail of lending institutions, whether it’s a traditional bank or non-banking alternative financing company. The main reason this is the case is due to one detestable word in lending, “default”. The goal of this small piece is not to educate you about all the processes of banks, lending institutions, or all the steps and analyses that exist in the framework of credit analysis and risks management. Rather, it is to neutrally convey to the borrower a few details of the most reviewed aspects of these elements associated with procuring a loan.

As a borrower if you have not heard of the 5 C’s from your Banker, Loan Officer, Loan Originator, Mortgage Broker, Underwriter, Credit Officer or Loan Consultant, chances are you were not paying close attention to some of their initial communication to assess if there is “merit” to proceed further. Underwriters at banks and lending institutions use the 5 C’s below to determine credit worthiness, liquidity profile and a host of other things to either (i) move forward with a loan process or (ii) end the conversation at the onset due to too many potential risk factors. Below is a quick primer about the 5 C’s:

(1) Character: Banks and lenders will always look at the reputation of a borrower (i.e. is she a good and credible person? Has she been involved with the law wrongfully many times? Etc.)
(2) Capacity: This has to do with the borrower’s financials or his/her company’s balance sheet. Banks and lenders will look at how strong borrowers’ financial statements are and other financial situations to understand if it is in their best interest to provide a loan.
(3) Capital: Banks and lenders focus on the importance of liquidity profile of the borrower (i.e. income to expense ratio, other debt and income sources that could mitigate future loss)
(4) Conditions: No bank or lender will ever lend without knowing about current, future trends and other important macro and micro economic conditions of the overall market (based on many trends, historical figures, other forecasting) and the local market they’re going to lend in.
(5) Collateral: A lender will always find about the best collaterals before lending to borrowers to make sure in any case of default, any loss can be recuperated.

Firstly, one must ask what does credit risk even mean? To put it simply, credit risk refers to the risks of default on a loan by a borrower. This is crucial because a bank and lender will be in a precarious situation of losing interest payment as a risk and loan principal. A property’s ability to pay debt service is determined by its net operating income (NOI). Likewise, a company’s ability to repay its debt is based on its capacity to generate cash flow (CF) from operations, asset sales or other external factors that can produce cash. As such, if a lender suspects from preliminary underwriting that NOI and CF are poor and will be unsustainable during the first 1 to 3 years of operations along with poor metrics, ratios, providing a loan will be extremely slim.

Secondly, a borrower will default when he/she fails to make debt service based on many factors, which is why the 5C’s of underwriting are critical in a loan process. Unlike a firm where the bank or lender can adjust the loan payment schedule, increase the interest rate, or seek to have the firm insolvent to protect its balance sheet. This will differ for a real estate loan because lending on a property (a tangible asset, but can’t be turn into cash fast) is very different than loaning to a company that its assets are usually easier to convert into liquid capital.

Thirdly, to mitigate this kryptonite “default”, banks and lenders rely heavily on specific metrics and financial ratios, thereby helping with robust risks management. These metrics and ratios help (i) quantify the borrower’s credit risk before a loan is granted; (ii) evaluate the borrowers, the company and/or property qualitatively and quantitatively; (iii) once a loan is granted these ratios and metrics will serve as early warning sign for increased credit risk. For commercial real estate banks and lenders will rely heavily on a few metrics, however these three metrics: debt yield (DY), debt service coverage ratio (DSCR), and loan-to-value (LTV) will either make or break the loan. To understand the concepts related to these lending metrics in relationship to credit risk, liquidity and risk management review the page at www.refivest.com titled, “Metrics”. For a firm and company, banks and lenders will look at many ratios before issuing a loan and the emphasis is highly placed on:

(1) Liquidity: The ability for the company to meet its short-term obligations. Basically, will the firm be able to pay interest payments and principal in the short-term when its due?
(2) Quick/Current ratio: These are ratios that measure the liquidity of the firm, company – meaning, how high or low is liquidity? can it be converted to cash fast to pay back current liabilities? Usually the higher the ratios, the stronger liquidity the company has. A current ratio greater than 2 is good and lower than 1 is weak. As for quick ratio, greater than 1 is good and lower than 0 is weak.
(3) Turnover ratios: Banks will use them (account receivables, payables and inventory) to measure the efficiency of how a company uses components of working capital.

Lastly, the metrics and ratios discussed, from a credit analysis and risk management perspective will allow a bank and lender to determine: early financing signs of distress, short and long-term profitability, leverage position, credit ratings, borrowers’ characters in association to default risk, etc. From the bank and lender’s point of view credit analysis involve at least 7 steps. A borrower must pass these credit risks tests and all seven levels must be in the lender’s best interest to mitigate risks in the likelihood of default. What are they in no particular orders? For commercial real estate loan issuance, the 5 C’s of underwriting previously discussed along with the 3 most important metrics (DY, DSCR and LTV) will suffice.

A lender will know within the first phase of underwriting a loan if the borrower and his assets are worth the risks that it will manage. If the risks proportion are too high (i.e. high tenancy turnover ratio, lack of reserves, to TI/LC (tenants improvement/leasing commission) or capital expenditures account, poor credit retail tenants, neighborhood in decline, borrower with past credit issues more than 3 times, and so much more) traditional banks will not provide a loan to the borrower. Some alternative non-banking institutions will consider such a loan based on other specific criteria, and the loan will be more expensive. In terms of a firm, the steps for credit analysis will typically be:

(1) Story behind the business and understanding such business (The lender wants to understand in important detail why is the borrower needs a loan and why now)
(2) Accounting mistakes – according to GAAP (generally accepted account principles). Are the books sound and in order? Are there any disparities in the numbers on balance sheet, etc.?
(3) Profitability evaluation (ratios, trends, and financial conditions will be looked at heavily)
(4) Proforma analysis and Cash flow forecasting (lenders will make sure they are strong from the start otherwise no deal)
(5) Due diligence – this is different than real estate because it typically occurs a little later in the process.
(6) Risks assessment – impact on ability to pay and loss mitigation if default occurs
(7) Management and monitoring – ongoing process of risk management for future events.

With all the red ropes and barriers to jump over, what should a borrower do to increase his/her likelihood of obtaining a loan? There is an article at Refivest.com titled “3 Crucial Conversational Points That Will Have Lenders Salivating Over You” that will provide the borrower with some interesting take away to be better prepared. Additionally, there is another article title, “Five Big Pitfalls Small Business Owners Fall into and How to Circumvent Them” it will also educate the small business owner, middle tier company or much larger firm on some of the business principles that are critical when it comes to obtaining financing with a bank and lender.

Ultimately, there are many moving parts in the process of obtaining a loan from inception, through application until the loan is closed. The focus of underwriting, credit analysis and risks management have become the cornerstone of the process. Banks and lenders are not only in a business of providing loans and other financial services, but also of mitigating and managing risks with any associated assets, entity, sponsor or firm they plan to fund. As a result, it is essential for the enthused borrower to understand to a certain degree the nucleus of how these processes work and the likelihood of getting funded.


By: Ibsen Alexandre
Ibsen Alexandre offers his opinions about real estate finance, business, and investment at www.Refivest.Com and other real estate publications. He can be reached at ibalexandre@refivest.com

The opinions expressed herein are those of the author(s) and do not reflect the view of a particular firm, its clients, any respective affiliates nor any Media Platform. This article is for educational general purposes only and is not intended to be and should not be taken as solicitation to lend.

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