By Glenda Brass, MBA
I’ve spent the last few weeks explaining how relatively easy it is to get a commercial loan utilizing private or hard financing because most of that money is equity based. However, when it comes to traditional lending, an individual or business will be judged on how well they measure up to “The 4 C’s.” (Because of space limitations, this is simplified.)
Character – Character is mainly how the individual has performed on their previous debt obligations. Basically, have the borrowers handled their financial commitments in the past and paid back their loans? Do they have experience and knowledge of what they are embarking upon? Unlike the private lenders, traditional lenders will want to see personal and (business) credit reports (with good scores), a written business plan (dependent upon the type of commercial property), bank statements to evaluate performance, personal financials, etc.
Capacity – Capacity or what most bankers call, cash flow, is the ability of the buyer to repay debt. Can the buyer generate enough “cash flow” to pay back the debt requested? Typically, “debt service” is calculated by taking net income (profit after taxes), and adding back depreciation and interest expense, which is then divided by annual principal and interest payments of all debt for the buyer. Typically, a bank will want to see a debt service coverage ratio of 1.2x or greater (the availability of cash available to service your debt). Anything less doesn’t leave the bank or the borrower much room for error if something should come up unexpectedly that affects performance, a.k.a. cash flow! I won’t get into the calculation here, but the bank does its homework.
Collateral – For a bank, the understanding of the monetary value of the collateral (the property used to secure the loan) is very important. The collateral is something that is checked (initially via appraisal) or reviewed throughout the life of the loan to ensure it maintains its value. When analyzing a loan request, the underwriter examines cash flow first as repaying the loan, not collateral. The collateral gives the bank more security and reduces the risk in making the loan knowing that if something does arise in the business and cash flow is affected, there is value in the collateral that can be liquidated to repay the loan.
Capital – Capital is the ability to sustain a downturn in the economy and also establishes the commitment of the borrower to the project. A low capital position of an individual raises questions by the bank about their commitment to the project. If the buyer cannot put up 20%-30% capital it will be difficult for that individual to secure traditional, favorable financing. In the bank's view, if the owner isn’t willing to put up their own capital, why should the bank put their capital at risk in making the loan?
In some instances conditions are also evaluated. Evaluating current economic conditions at the time a loan is requested to determine the feasibility of approving a loan request may be examined contingent on the market we’re in. Today’s market is much improved from the market prior to 2013.
So there you have it. I hope that this will be helpful to you as you look to approach a traditional bank for financing. Most importantly, make certain your character remains solid and that your project has capacity to generate cash flow and is valued appropriately. Finally, be prepared to bring some of your own funds to the table. If you’re an owner user, SBA or some other grant program may come in handy to help with the capital, but you should do your own saving to ensure your strong position going in.