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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   July 2010

Scrutiny Is the New Normal

It's back to basics, as the five C's of credit rule lenders' guidelines

Scrutiny Is the New Normal

From 2005 to '07, many commercial mortgage lenders based their underwriting decisions on strong future projections. In that period, lenders typically considered full occupancy in an office building or retail strip mall to be a loan's primary strength. They would look less at the borrower because the property's tenants often fueled the rental income to support the loan comfortably.

Most lenders didn't consider the potential decline in tenants' businesses, however.

As these businesses began to fail, commercial, retail and office vacancies increased steadily. As the vacancies grew, property values declined quickly. Now property values are at eight- to 10-year lows, and many loans are near 110-percent loan to value (LTV).

As a result, many property-owners who need to refinance their now-adjustable rates cannot get a loan. Commercial mortgage brokers can help clients prepare for the "new normal" of commercial lending -- which is a return to the basics of lending. Brokers should understand what lenders now look for in a loan, as well as how borrowers who don't qualify can best position themselves for the future.

The 5 C's plus one

In today's market, banks must consider the property condition and location, the tenants, and lease lengths and terms. Property type matters significantly. They also are avoiding certain properties, such as restaurants and those with automotive purposes. There is greater scrutiny on the borrower and their reserves. Essentially, banks have returned to the five C's of credit: character, capacity, collateral, capital and current market conditions.

Lenders also are considering whether the borrower is a current customer of the bank and looking at the depository relationship's weight and history. Guarantors' strength and their contingent liabilities also play into the mix. Banks are taking extreme caution to prevent business-owners and investors from becoming overleveraged and therefore are putting the most prominence on the second C: capacity.

In addition, loan pricing typically is based on any type of risk in all of the above-mentioned criteria.

Where are the loans?

Because of past lending mistakes, regulations have become more stringent, and banks must now keep higher capital and reserve levels. This decreases the funds available to lend.

The banks that survived through the downturn have done so because of diverse concentration in the market and conservative lending practices. The same practices and increased regulations and risk have resulted in a new age of caution, decreased competition and difficulty for any borrower today, investors and business-owners alike.

Lenders now prefer to lend money to certain types of borrowers and only for certain property types. They require full documentation, good-quality properties in solid locations, properties with strong tenants in surviving industries and solid leases, or seasoned business-owners with moderate cash flow and strong credit.

Because of the many vacancies on the market, construction loans are mostly off the table, as are office, single-purpose properties and retail strip centers. Essentially, in today's market, brokers may find success by working with the following:

  • Investors with cash reserves and the ability to put almost 50-percent down on solid properties in major metropolitan areas. Lenders are looking more at property location, cash flow, sustainability and value. They will more likely consider strong-quality investment properties in major areas with good local employment levels. Multifamily properties traditionally are the best-performing products in the long haul, especially in areas of faster employment growth.
  • Strong, seasoned business-owners seeking properties for their own business. A lender will more likely consider a 20-year-old business that has weathered the storm and that has reserves and solid cash flow over one that has only operated three years.
    Many banks like the U.S. Small Business Administration's (SBA's) 504 product for owner-occupied purchases because of the split in loans. The bank provides a first-mortgage loan with 50-percent LTV, and the SBA covers 40 percent of the purchase price. This is a desirable situation for the bank because of the low LTV. It also is desirable for borrowers because the blended rate between the two loans lets them put as little as 10 percent down.
  • Recession-proof industries, such as medical, dental and legal. These typically are stable industries in most economic crunches because people always will need their services. Lenders often will like fully occupied medical or legal offices that have strong debt-coverage ratios and a purchaser with strong cash reserves. Again, keep in mind properties in major metropolitan areas will be stronger rather than those in a quick-to-grow and fast-to-decline rural area.

Prepare for the future

For property-owner clients unable to get a loan because they are overleveraged, lack reserves or have substandard credit, the best thing you can offer them is knowledge and understanding.

Help your clients see how they can prepare for tomorrow. Above all, don't promise them loans that just aren't around.

Suggest they scale back as much as possible, repair their credit scores if needed and consult with their tax adviser to determine if they are writing off too much income. 

Business-owners often write off too much from their bottom line on their tax returns, and banks evaluate their reported income to consider their ability to afford the loan. 

In some cases, consulting with their tax professional and adjusting how they report their income to show profitability can be more beneficial than certain write-offs.

Brokers will find a lot of value in providing clarity to their clients on the market and helping clients adjust to today's new normal: lending based on value, quality, location and borrower strength.


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