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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   April 2013

7 Credit Hurdles to Clear

Understand how credit officers score the quality of their deals

In the commercial mortgage industry, top performers typically are the ones who can predict, with reasonable accuracy, the reaction and feedback of the credit underwriters for each of the lenders to which they present a loan request. That ability to predict — as well as the knowledge of how standards vary from one lender to the next — often distinguishes professionals from pretenders in the mortgage business. With this knowledge, mortgage professionals also tend to under-promise and over-deliver to avoid unpleasant surprises down the road.

Mortgage professionals who work on the banking or credit-union side of commercial real estate lending often have a clear idea of the risk-analysis methodology or rating system their institutions use. In the past, people were taught the five C’s of credit: collateral, capital, character, credit history and market conditions. Since the financial meltdown, however, these criteria have given way to new rating schemata based on seven risk categories.c_2013-04_thomas_graph_ph

For most banks and credit unions, lending to real estate projects — emphasizing collateral and conditions in the market — is a thing of the past. Today, sponsorship is just as important, if not more important, than project quality and curb appeal. The seven risk factors are credit scores and history; length of employment and experience; global cash flow; personal cash flow; global liquidity; project cash flow (or business cash flow); and loan-to-value (LTV) ratio. 

Commercial mortgage brokers can think of these seven categories as hurdles on a racetrack: The more you clear, the more likely it is that you’ll win the race. If you fail more than one, the loan probably will be declined. In particular, many transactions have been declined for failing the global liquidity test, which many credit officers consider to be the most important risk category.

Brokers also should be aware that credit officers are responsible for correctly approving, booking, monitoring and annually grading each loan in their portfolios. They are tangentially — and sometimes personally — responsible for collection. As a result, they have a different perspective than many sales professionals, who tend to focus on issues like relationships with customers, banks and Realtors, or compensating factors such as low LTVs or the given project’s debt-service coverage. Although these aspects are important, it is critical to understand that the mindset of today’s credit officer is focused on one thing: portfolio quality and performance. 

To communicate with credit officers, brokers must be conversant with the credit officers’ grading system. Here is a brief look at each of the seven credit factors and how to construct an example of a grading system: 

1. Credit score

For the best rating (or a 1), sponsors should show a credit score of 720 (FICO or mid-FICO) or higher. Credit-score rating can comprise 5 percent of the customer’s total grade.

2. Experience

The applicant should have at least 10 years of management and job experience in the same field to get a 1, which is worth 5 percent of the total score for a given loan.

3. Global cash flow

The term “global cash flow” may sound complex, but it’s calculated simply by:

  • Determining the total cash available (TCA), which is defined as the project’s net operating income (NOI) for the subject property plus the project NOI for any other real estate. In the case of a business, the TCA will be the earnings before interest, taxes, depreciation and amortization (EBITDA). Then add the individual salaries, interest, dividends and other taxable income for each sponsor; the result will be the TCA.
  • Determining the total cash required (TCR), which is defined as the debt service for the loan, the debt service for all other real estate or business loans, and the debt service for personal revolving, home and installment credit.
  • Dividing the TCA by the TCR, which finally calculates the global cash flow. 

To get a 1, banks typically need at least a 1.4-to-1 global cash flow — i.e., $1.4 million coming in and less than $1 million going out. In this model, the global cash flow is 20 percent of the final grade.

4. Personal cash flow

Similar to the global cash flow, the personal cash flow just focuses on the individual. For instance, it is calculated by dividing the total cash available (wages, salaries, net cash flow from real estate, EBITDA from businesses owned and tax returns) by the TCR for service, installments and revolving debt. The typical standard for personal cash flow is 2-to-1, and it makes up 15 percent of the final grade.

5. Business or project cash flow

Calculating the business or project cash flow is done by dividing a business EBITDA or a project NOI by debt service. This typically is required to be a ratio of 1.2-to-1 or better. The business cash flow is 15 percent of the grade in this model.

6. Global liquidity

Divide the total cash and cash equivalents by the monthly debt service. This will tell you the number of months your liquidity cushion is good for, should a disaster strike. For example, if you are financing an office building with a new loan that has $10,000 a month in new debt service, and the customer has another $5,000 in debt service of other loans, the cash required is $15,000 a month. If that customer has a verified amount of $150,000 in cash and cash equivalents, then the liquidity cushion is for 10 months. In this risk category, having a liquidity cushion of 12 months gets the highest rating. Global liquidity makes up 15 percent of the total risk score in this model.

7. Loan-to-value ratio

An LTV of 75 percent or less typically earns the top rating, based on the appraisal review. This is worth 25 percent of the total risk score.

• • • 

Commercial mortgage brokers who keep these points in mind not only will be prepared to present deals that meet lenders’ criteria, they also will be in a position to advise clients on what to do to streamline their deals and ensure they are fundable. By accomplishing these goals, mortgage professionals can forge positive experiences with lenders and borrowers alike.  


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