DEBT COVERAGE

In my opinion by far the most important single consideration in commercial loan origination is debt coverage.

Whether a borrower has paid his Target credit card promptly is of absolutely no moment. The difference between a 650 credit score and a 690 credit score is meaningless. Obviously a 750 or better credit score is a strong plus, but I don't see a lot of those to begin with. Good credit may or may not be an indicia of good character, and a borrower with a good credit history is probably apt to be more conscientious in making payments than one with a poor credit history. A borrower with no money however has no more ability to pay if he has great credit than if he has horrible credit. All the good credit in the world will not get the bank to cover his checks, at least not for long, if there is no money in the account.

In a very real sense the assumed value of collateral means very little, unless the lender is willing to own it, other than as an indicia that someone might be willing to buy the collateral for some more or less expected sum at foreclosure, or within the reasonably near future thereafter. My extensive foreclosure experience has taught me that while a prudent handling of post foreclosure collateral can be extremely profitable---in fact frequently more profitable than the loan itself would have been if promptly and fully paid---there is in fact very little certainty that in any particular foreclosure the lender is not going to have to own the collateral for a while before getting his money back, and no assurance, absent an enormous amount of collateral, that forced sale of the collateral will be sufficient to get that money back.

I once had a mortgage on EIGHT pieces of collateral, all with apparent fair equity and only got paid off fully while foreclosing the last of these parcels, largely because the idiot borrower was unwilling to just sell any of them himself and maximize the sales price, rather than letting them all gets sold at foreclosure for far less than value. Human behavior is difficult to predict and borrower behavior is impossible to predict.

The best commercial practice is for the lender to have complete control of the entity which has actual ownership of the collateral, preventing the borrower from interposing senseless bankruptcies for the sole purpose of delaying the inevitable eventual forced sale(s) and enabling the orderly deposition of the collateral for maximum value. Even then there is no certainty of recovery of the complete loan amount. Most lenders in fact assume that collateral will on average only ready 80% or so of the book loan amount.

All that a lender really has to rely on to get his money back with some sort of somewhat predictable certainty is the borrowers having a steady stream of cash coming in to make the payments, and the borrower's not having alternative bills to pay that he deems more important. Most commercial lenders require total cash flow generated by an individual property to equal 120% or more of the amount needed to service the debt.

Multiple pieces of income producing collateral however require more analysis that something like the 120% rule. The reality in fact is that almost 120% coverage is needed on EVERY PROPERTY the borrower owns, since a property with a negative cash flow coverage is apt to become a "black hole" into which the borrower throws money to his eventual destruction.

When I did consumer lending I was always surprised at consumers prioritizing their credit card bills over their mortgage payments, at their willingness to mortgage the house to the hilt to pay their unsecured credit card bills. Similarly, many commercial borrowers who own multiple investment properties will throw good money after bad trying to keep a very bad property, only to end up risking the loss of their good properties.

Ideally a lender's taking title to income producing property would also serve to control the application of the stream of income. Unfortunately as a practical matter this would mean having to manage the collateral during the loan term and result in all sorts of complications. Very large properties however will generally be managed by third party managers, or the tenants will a least pay their rents directly to the institutional lender pursuant to an assignment of lease.

For smaller real estate loans to a borrower who owns a handful of properties, perhaps even with tenants who frequently pay cash, such as in rooming and half way houses, there is no alternative to the borrower collecting the rents. In such loan situations the lender should probably do two things: (1) hesitate to loan to any borrower who has in his portfolio obvious problem (black hole!!!) properties which he might not be able handle; (2) require periodic cash flow reports on all properties (even those not used as collateral) to see where the money is going. Obviously the latter is very important in situations where the collateral mortgage is junior to a senior mortgage, or where there is no tax escrow agreement.

Assuring that the properties remain well maintained is another issue that actually is a debt coverage issue: if the borrower does not have sufficient cash flow to maintain the property there are going to be problems in the long run.

The big problem with real estate development loans is ALWAYS debt coverage. Since such property is not yet income producing (and there is in fact no certainly that the development property will ever be income producing!!!), unless there is adequate cash flow coming from some other source, the lender essentially becomes the borrower's partner the day he makes the loan. The only exception to this would be a "loan to own" situation where the lender would be perfectly happy to just get the collateral in satisfaction of the loan amount.

Other than real estate income, other sources of cash flow suitable for debt coverage might be such things as an annuity payment, earned income, or cash flow generated by the borrower's other business.

Available cash from business cash flow can be very difficult to evaluate. I recently learned from talking with a rural veterinarian that she grossed over one million dollars a year but had available cash flow after paying her practice bills of a little more than $100K a year. From that $100K she had to feed her family and pay her daughter's tuition. Obviously, just assuming that the $1 million gross would provide adequate debt coverage for a loan would have been a big mistake.

Bottom line here is that THERE IS NOTHING MORE IMPORTANT THAN DEBT COVERAGE when you make a loan. 

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