Storm Clouds Surrounding the Commercial Loan Market!!

"No, as of March 1st, we are no longer offering commercial mortgages with Loan to Values (LTV's) in excess of 85%". That's the message I got yesterday from a commercial lender who prior to March 1st was aggressively offering 95% LTV's. What happened at midnight February 29th? Did the extra day (leap year) in February cause most lenders to change so abruptly?

Here are some of the ingredients prompting the change: This past week, the Wall Street Journal dedicated several columns suggesting that the commercial market was on its way down. To summarize, the Wall Street Journal showed that nonresidential construction was down 1.7% in January versus the prior month, office space sales declined 42% in the fourth quarter of 2007 right as the credit tightening began, and that The International Council of Shopping Centers announced that U.S. store closures could reach 5,770 up from 4,603 last year.

More storm clouds are on the horizon according to another article quoted in the Wall Street Journal. The article suggested that U.S.'s community banks are sitting on a commercial loan time bomb. Community banks have migrated to underwriting more commercial loans as they've been pushed out of the residential mortgage market by Wall Street money. "Small and midsized banks, with less than $10 billion in assets, have a total of $323 billion outstanding loans", the article stated. This represents approximately 285% of the remaining banks' capital.

Let's speculate that approximately 1% of those loans referenced above were written off by the community banks - for a total of $3 billion write off. Not only would that result in several community closing, but it would also reduce the lending capacity of those institutions by at least $32 billion (using a 10x factor due to the leverage employed by most banks). That means $32 billion in potential loans to you and me to buy real estate would evaporate.

Is the sky falling? No, not exactly.

Commercial loan delinquencies are still low at 1.94% in the forth quarter of 2007 (it did rise modestly over the prior year). In the 1990's the commercial loan delinquencies reached 10%, so we still have a long way to go. Many experts suggest the most weakness in the retail segment, which is most susceptible to the downward movement in the national economy. So what does all this mean to you and me, who deal in the small balance commercial loan market? Here's what I think:

• Higher equity requirements. A contraction in the loan to value ratio means higher equity contributions by the owner/investor. Solution: If the cash isn't available to increase the equity contribution to complete the deal, approach the seller about a seller second mortgage. Your primary financing institution will look at the seller second as quasi-equity due to their 1st priority in the transaction.


• As properties come under increased scrutiny, the borrower's underlying credit will become increasingly important. So having a healthy credit score backed by personal liquidity will help you get that deal completed.


• Find other creative ways to finance the deal. For example, you could arrange a master lease agreement with an option to buy (at the current market value) with the owner. Under the master lease agreement you pay the owner a monthly lease payment but you run the property including collecting rent and paying expenses. Your goal is to then increase the value of the property and cash flow during the term of the lease (usually three to five years). Remember your option is based on the value today, not the value your going to create during the lease term. You could also negotiate that a portion of your lease payment go towards the option price.


• Buy on option on the property today for a small upfront fee. This locks up the property while you find a solution to the financing arrangement. Make sure that the upfront option price goes towards the purchase price.

Keep looking at the horizon for those storm clouds and I'll be happy to be your real estate weatherman!! Remember good deals get done!

How do I buy my competitor? Will my bank help me?

Acquisition financing has always been challenging for banks. Why? Typically, the multiple being paid exceeds the tangible assets found on the acquired company's balance sheet. This collateral shortfall - as perceived by the bank - is a hurdle that most banks require an equity contribution to cover. The bank would also want you to have "skin" in the game by requiring an equity contributions. Equity contributions have hovered between 20% to 40% since 1996.

To figuire out how much your bank would lend on an acquistions, you must calculate the lendable value of the tangible assets, determine the debt service capability of the acquired company, and calculate the overall balance sheet and cash flow leverage at closing. Let's review each one seperately.

Lendable Value of the Tangible Assets:
Create a simple spreadsheet and put the assets in the first column, and the values found on the balance sheet of the acquired company. Typical assets include: Account receivable, Inventory (excluding Work-in-Process Inventory), Machinery and Equipment, and the Real Estate. Other assets such as customer lists, trade names are all assets, but not lendable assets from the bank's point of view.

In the next column put the following advance rate percentages next to each asset class: Account Receivable at 80%, Inventory at 50%, Machinery and Equipment at 50% of net book value, 70% of the orderly liquidation value, 90% of the forced liquidation value, and 80% on the value of any real estate. Total the net lendable value to determine the total lendable value of the acquired assets. Subtract 15% from the lendable value of the accounts recievable and inventory to account for working capital availibility that all banks will require.

Determine the Debt Service Capability of the Acquired Company's Cash Flow:
Start with the acquired company's EBITDA (Earnings before interest, taxes, depreciation, and amortization). Then adjust the cash flow from any expenses that are eliminated by the fact you are acquiring the company. These expenses might include: Prior owner's excess compensation and benefits, Miscellaneous professional fees, and rent. Once you've calculated the adjusted EBITDA, take the total lendable value of the tangible assets calculated above (minus the 15% working capital adjustment), and amortize that amount over seven year period to determine your annual principal payment. Most banks will set loan amortizations and maturities on acquisition debt to be between 5 to 7 years. In some cases, I've seen 10 years - when supported with an SBA guarantee or other credit enhancement. Apply a conservative interest rate on the debt to determine the total annual interest exepense. Add the total interest expense and principal payment to determine your total debt service.

Then take your total adjusted EBITDA and project your future capital expenditures. Subtract the capital expenditures from the EBTIDA to determine your free cash flow to service debt. Take that cash flow and divide into it the total annual principal and interest payments. This ratio cannot be lower than 1.20x. If it comes in below that figure, then more equity needs to go into the transaction. Siginificant cushion over the ratio might be a way to justify a lower equity contribution!

The last step is to determine the Day One balance sheet and cash flow leverage. Balance sheet leverage is determined by dividing your total liabilities by your total shareholders' equity. This ratio should be below 4.0x, although some bank's might be fine with 5.0x. Total calculate your cash flow leverage, divide your adjusted EBITDA by your total liabilities. This ratio should be below 5.0x and again some bank's might accept 6.0x.

Your banker will help you if you present to information calcluated above in the form of a formal presentation which would include projections. The quality of the presentation is a signal to the bank as to wether you are on the ball with this significant transaction. Listen to suggestions from your banker. Your banker might even suprise you and lend you 90% of the acquisition price, or he might say that this transaction would push your total debt over the risk tolerance of the bank. In that case you've got to go find a bank to help you complete the transaction.