Business Loans: The New Rules
So your business is changing. And you’ve decided to embark on a construction project in order to fulfill these needs. Maybe you’re expanding your offices to accommodate growth, or adding a warehouse to centralize your operations under one roof. Perhaps you need an entirely new facility and are debating whether to renovate an existing building or build new. Unfortunately, many of these projects cannot be realized without obtaining outside financing. Lending has become a whole new game, but many are not learning about the new rules until they show up to play, only to find they are ineligible or don’t meet the criteria.
Many lenders from past years are no longer making loans for various reasons. It may be that they have no money or have higher capitalization requirements to meet, or they have changed their target audience, or the bar for qualification is so high that it is constructively the same thing as not lending. Whatever the reason, the effect is the same: Fewer places to find money with which to build. So what do you do?
Seven Things You Will Likely Need
First, assemble your information. Be prepared to tell your story. Today, qualifying for a loan requires a much higher degree of documentation regarding the business’ finances. Items your packet should include:
- Some history on the business and its leadership.
- At least three full years of personal and/or company tax returns.
- At least three full years of income/expense statements, plus the current partial year.
- A recent balance sheet showing the assets and liabilities of the borrower. This document should show any buildings and land the borrower currently owns, as well as any capital on hand.
- A projected income/expense statement showing how the business intends to cover the debt service of the new facility. Will there be an increase in sales? Will new employees be hired? Will there be a reduction in existing expenses? What additional expenses will be incurred after the project is complete?
- Tell your story. Be prepared to explain any variances or challenges the company may have experienced and offer your plan to overcome them.
- An explanation of the scope of work desired, including conceptual drawings and specifications if available, as well as an estimate of the complete project cost. Often times this information can be generated by a design/build contractor for a nominal fee.
In today’s lending environment, one of the most notable changes has been the increased emphasis placed by bank examiners on the lending institution’s ability to satisfy federal and state regulations. Therefore, what used to be a relatively manageable task for the typical borrower has become much more cumbersome. Two additional changes are found in the calculations for loan-to-value (LTV) and the net income with which to service debt. Very few lenders will loan 80% of project value; many have dropped to only 70%. And project value is typically declared to be the lesser of the cost of the completed project or the appraised value. Net income is also closely scrutinized by a lending institution. Be prepared to demonstrate that cash flow will cover the new debt service.
The Five “C”s
Most lenders are interested in the five C’s: Capital, Cash Flow, Collateral, Credit and Character. Capital demonstrates liquidity and ability to provide a down payment, typically 20-30% of the project value when working with traditional lenders. Cash Flow or income is an indication of the borrower’s ability to repay the loan. An approximate guideline is that the business’ total Debt Coverage Ratio (DCR) should be at least 1.2 to 1.25. A calculated DCR of 1.25 implies that the property net operating income is 1.25 times higher than the annual payment required to service the mortgage loan. Collateral assures the bank that they will be protected. The more un-encumbered collateral you show, the better. Credit, of course, demonstrates the past payment history of the business. Remember that your lender has much more flexibility if you are current on your obligations. And Character, of course, speaks to the personal commitment of the borrower to meet their obligations.
Selecting A Lender
Once the information is assembled and the story told, consider to whom to present the information. Certainly consider conventional financing as an option. Start by speaking to a loan officer at the business’ current bank. But don’t forget about the local community banks and credit unions; their regulations are often less strict than many of the mega-banks. For owner-occupied projects, SBA financing could be a consideration, typically offering less capital outlay and competitive rates. Finally, ask other business leaders about their experiences and who they used to finance their projects.
Once meetings with potential lenders are scheduled, be prepared with a list of questions. Some issues to address might include:
- Does the lender offer a construction-perm loan that will require one-time closing costs?
- What are estimated closing costs, including any draw fees?
- What is the allotted time for the interest-only construction period? What happens if the actual project construction exceeds the allotted time?
- When can interest rates and terms be “locked”?
- Will any out-of-pocket payment of project design and development be applied toward the borrower’s equity requirement?
- Does the loan include pre-payment penalties? In other words, will the borrower be required to pay a penalty fee if the loan is re-financed or paid off during that penalty period?
- Will the lender file and record the Notice of Commencement and prepare title updates at each builder draw to assure the property remains lien free?
- Will the lender require the builder to supply Release of Liens to assure the lower tier subcontractors and suppliers are paid?
- At its completion, will the project qualify for SBA financing? What is required?
While times have changed and lending is a whole new game, you can win. Understand the new rules, be realistic about your expectations, and be prepared. The more prepared you are to answer the lender’s questions and present your story, the better your chances to obtain competitive loan terms. Good luck!