To many, the criteria that a lender uses to approve a commercial real estate loan is a mystery. In reality, loan approval criteria are fairly straightforward. What can cause complications is the fact that they are a little bit different for each lender and highly dependent on the property type and current economic conditions.
Despite the differences, each lender looks for the same general characteristics in every loan request. Colloquially, they are known as the “Five Cs of Credit.” In order to understand what they are and why they matter, it is first important to discuss the basis for all underwriting decisions, the lender’s credit policy.
What is the Credit Policy?
A credit policy is a lengthy, technical document that describes the lender’s approach to issuing credit and it is the basis for all approval/denial decisions. When a lender underwrites a loan, what they are really doing is analyzing the specifics of the request and comparing them to credit policy guidelines to see if it qualifies for approval.
Typically, lenders are reluctant to divulge the contents of their credit policy, but they all contain the same general information:
- What types of commercial real estate loans they are willing to make – e.g. installment loans, lines of credit, bridge loans, and commercial mortgages.
- Acceptable loan amounts, which may be governed by regulatory requirements.
- Who is able to approve the loans and what their approval authority limits are.
- What types of commercial properties are unacceptable – e.g. hotels, restaurants, and mobile homes.
- An approval “box” that describes acceptable loan parameters like: Loan-to-value (LTV) ratios, amortization, and debt service coverage ratios.
Credit policies are not static documents. They are constantly updated and approval criteria are refined as market conditions change. For example, if economic conditions are negative for multifamily properties, the credit policy may be updated to make multifamily loans more difficult to obtain.
Basic knowledge of a lender’s credit policy provides the needed context for a discussion of the five “Cs” of credit.
#1 – Character
Every commercial property loan request can be traced to one or more sponsors / borrowers. Depending on the structure of the deal, this could be an individual or a separate business entity. Regardless, lenders will perform due diligence on their character to determine if it is suitable for a loan. They do this by pulling a credit report and by speaking with other industry participants to gauge their reputation. Within the credit report and reference conversations, lenders are looking for things like:
- Credit Score
- Excessive late payments
- Prior bankruptcies
- Prior experience with the property and/or loan type
- Prior foreclosures
The point of this analysis is to ensure that the borrower(s) are of high character, which maximizes the chances that they will repay the loan.
#2 – Capacity
There are two components to a loan’s capacity analysis, the sponsor and the property.
With regard to the property, the lender seeks to determine if it currently produces or will produce enough cash flow to make the required loan payments. To do this, they analyze at least two, sometimes three sources of repayment. The primary source of repayment is the property’s cash flow so the lender will create a property proforma that models lease rates, operating expenses, and vacancy levels to identify the amount of cash available to service the debt. If it provides a debt service coverage ratio (DSCR) that meets credit policy requirements, it is a positive.
The secondary source of repayment is the sale of the property. This means that a borrower default would trigger the lender to take back the property and sell it. Sale proceeds will be used to pay down the loan balance. This type of analysis requires an accurate feel for the value of the property at the time of underwriting.
The third source of repayment is where the sponsor’s capacity comes into play. If the borrower defaults and the sale of the property does not provide enough money to pay the loan balance to $0, the lender could turn to the sponsor(s) for the difference. This means that the lender wants to have a good feel for the sponsor’s personal financial capacity including their liquidity, total assets, and total liabilities. If they are robust, it is also a positive for the transaction.
#3 – Capital
In many ways, approving a loan means that the lender becomes a business partner to the borrower. As such, the lender wants to make sure that the borrower is going to hold up their end of the bargain. One of the ways they do this is to assess the down payment they bring to the transaction. There are two ways to measure this.
First is the loan to value ratio. As an indicator of their commitment, the lender wants to see the borrower bring a significant amount of their own capital into the deal. Usually, they like to see at least 20% of the property’s value.
Second is the source of equity. It is one thing for the borrower to raise money from investors and contribute it to the deal. It is another thing altogether for them to invest their own money. The latter is the preferred scenario because the borrower is personally invested in the deal and less likely to walk away if it goes bad.
#4 – Conditions
There are two types of conditions that a lender reviews before approving a CRE loan request, loan conditions and market conditions.
Loan conditions have to do with the parameters of the proposed loan. If the interest rate, loan term, and payment structure are within the acceptable bounds of the lender’s credit policy, it is a positive.
Market conditions can be a little bit more tricky to predict. These include things like the state of financial markets, job creation trends, housing starts and net people migration. These macroeconomic factors can have a significant impact on the success of an investment and lenders want to make sure they are on the right side of them.
#5 – Collateral
Lenders are in the financing business, not the real estate business. As such, the number one question with regard to collateral is, if the borrower defaults, can the lender sell the property for enough money to pay off the loan balance?
To answer this question, the lender will review the characteristics of the real estate property that could potentially make it desirable to buyers. This includes things like: location, zoning, leasing activity, parking, purchase price, net operating income, rental rates, amenities, competition, ingress/egress, appraised value, and current rent roll.
The One Exception
There is one major exception to the above. If a commercial lender is making loans backed by Fannie Mae and/or Freddie Mac, there is much less leeway with the approval criteria. In these cases, they must abide by the origination criteria established by these governmental agencies and underwrite deals to their specifications.
Summary and Conclusion
When evaluating a property for purchase, one of the biggest questions on the mind of real estate investors is, “can I get commercial real estate financing for this property?” The answer to this question lies in the lender’s analysis of the “five Cs.” If the results of the analysis align with the approval criteria in the lender’s credit policy, the real estate transaction is typically approved.
Interested In Learning More?
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