Credit Score and History

In years past, commercial real estate lenders paid little or no attention to personal credit scores and payment history. There was no need
to pull a credit report because commercial real estate lenders
believed credit risk was limited to the property and its cash flow, not
the individual. Commercial mortgages and loans, even to this day, do
not usually appear on personal credit reports, which is another reason why lenders tend to overlook credit scores and payment history.
Payment history on home mortgages, auto loans, student loans, and
credit cards, which are all consumer related, had no influence on a
commercial real estate lender’s decision concerning commercial
mortgages. Today, commercial real estate lenders have become
extremely conservative and now believe that personal credit scores
and payment history play a significant role in commercial mortgage
underwriting.
As previously stated, credit scores in general have not been all
that helpful in assessing credit risk concerning commercial mortgages because credit scores are based on consumer, not commercial,
loans. Credit scores, often referred to as FICO scores, are a reflection
of payment history, credit limits, and outstanding balances on home
mortgages, installment loans, revolving credit cards, auto loans, and
unsecured lines of credit shown on a credit report. FICO is a credit
scoring system designed by the Fair Isaac Corporation, hence the
acronym. Scores range from a low of 300 to a high of 850. Credit
reports are specifically designed for use by consumer lenders, rather
than by commercial real estate lenders or commercial lenders in general, for that matter. Even so, commercial real estate lenders are
beginning to see the value in credit reports and FICO scores in evaluating credit risk at the borrower or guarantor level. Unlike consumer lenders, commercial real estate lenders do not focus heavily
on the credit score itself, unless it is alarmingly low. A FICO score of
108 Commercial Mortgages 101
600 is low, but not too low to cause a lender to decline a commercial
real estate loan. This was especially true for conduit lenders, when
they were still originating loans. In general, most commercial real
estate lenders look beyond a mediocre or low score as long as there
is nothing extremely derogatory shown on the credit report such as
numerous late payments in excess of sixty to ninety days, collections,
summary judgments, or past bankruptcies. It’s also interesting to
note, scores usually have no impact on the terms and pricing of commercial real estate loans.
Credit reports and FICO scores pertain to individuals, not
borrowing entities. A borrowing entity is a legal entity such as a partnership, limited liability company, or corporation formed to purchase real estate assets. Borrowing entities can be existing or newly
formed. Newly formed entities won’t have prior tax filings, financial
statements, or credit history. The reason that this distinction between
an individual and a borrowing or legal entity is important is that
lenders require personal guarantees from individuals, referred to as
warm bodies. In other words, lenders look to the individual for the
full repayment and guarantee of the indebtedness, not the entity.
Legal or borrowing entities created for the sole purpose of owning
and operating a single commercial property are referred to as singleasset or special-purpose entities. As the name implies, single-asset
entities limit their assets to a single property. There are no other
assets whatsoever in a single-asset entity, and, in the absence of an
asset such as a commercial property, single-asset entities essentially
become shell companies. Guarantees offered by entities, referred to
as corporate guarantees, are worthless. In this situation, lenders will
require a guarantee from the general and managing partner, assuming that their personal net worth and credit is adequate for repayment of the loan. General partners or managing partners are individuals authorized to run and manage the partnership. In the good
old days, general partners or managing members would not give perFinancial Strength and Creditworthiness 109
sonal guarantees on behalf of the entity, primarily because they
owned a very small stake in the partnership and did not want to
shoulder 100 percent of the liability. In order to get around the personal guarantee requirement, general and managing partners would
search for nonrecourse loans. Nonrecourse loans do not require personal guarantees, and, in the event of default, foreclosure is the only
option for repayment of the loan. Nevertheless, whether the loan is
full recourse or nonrecourse, credit history and credit scores are not
to be taken heedlessly.

Five Adverse Credit Conditions Unacceptable to a
Commercial Lender

Unlike in years past, credit history and FICO scores today must be
nothing short of stellar. The minimum FICO score required for commercial real estate loans depends on the type of loan and varies from
lender to lender, but in general a FICO score below 600 is usually
where commercial lenders draw the line. Scores below 600 usually
mean that a borrower has serious credit problems. Commercial
lenders consider scores below 600 unacceptable and therefore usually decline the loan request, no matter how high the borrower’s net
worth is or how strong the real estate deal may be. If a borrower has
a better-than-average score of 650 or higher, many other types of disclosures or even just one adverse condition may simply overshadow a
good FICO score. Depending on the severity of the adverse condition, it is not unusual for a lender to deny a loan request because of
this one adverse condition. These adverse conditions, which are all
components of a FICO score, are classified into five groups and are
listed as follows:

  1. Late payment history
  2. High credit balances
  3. Collections and delinquent accounts
    110 Commercial Mortgages 101
  4. Lack of credit
  5. Foreclosures, bankruptcies, and summary judgments

Late Paymend History

A borrower’s payment history accounts for 35 percent of his FICO
score and is the single most important indication of his ability to
make consistent and timely mortgage payments.1 Experts estimate
that a payment that is at least thirty days past due can lower a FICO
score by as much as sixty points.2 Payments that are sixty to ninety
days past due really take a toll on a FICO score and may be the sole
reason for a lender’s decision to decline a commercial real estate
loan. Delinquent payments that were thirty, sixty, or ninety days late
usually require an explanation from the borrower. Depending on the
explanation and extenuating circumstances a lender must ultimately
decide whether or not the borrower presents too much risk based on
these late payments. Balances that have since been paid in full, even
those with numerous late payments in the past, have less and less
effect on a borrower’s score as time passes. Experts estimate that, on
average, past delinquencies that have since been resolved usually
lower a score by fifteen to twenty points.3 However, having other
credit lines on which a borrower has always paid on time mitigates
the impact of a single missed payment. In summary, the best way for
a borrower to ensure that she will not be turned down for a loan is to
have a squeaky clean payment history—and that may mean not even
one late payment. That may seem impossible, but if a borrower really wants be sure to qualify for that large commercial real estate loan,
having a perfect payment history will make all the difference in the
world. Late payments are loan killers.

High Credit Balances

A borrower’s total credit balance accounts for 30 percent of his FICO
Financial Strength and Creditworthiness 111
score and is the second most important indication of his ability to
manage debt.4 High credit card balances, numerous department
store credit cards, several automobile and installment loans, all with
high balances, spell disaster to a commercial real estate lender. These
debts can put a personal strain on a borrower, who may then be
tempted to steal or divert cash from the commercial property to keep
his personal debt in check. Financial hardship such as this is troublesome to a lender and could put the commercial real estate loan in
jeopardy. Credit reports rife with revolving credit card accounts and
installment loans can become problematic for the borrower if the
aggregate outstanding balance represents a high percentage of the
credit limit. Outstanding credit balances are measured as a percentage of the total credit limit. For example, a $5,000 balance on a
$10,000 Visa card represents a 50 percent credit balance, which is
normally considered too high. Not only does a high percentage of
debt to the credit limit reduce a borrower’s FICO score, it also sends
a signal to a commercial real estate lender that the borrower is
overextended and may default during a period of financial hardship.
Experts recommend that the balance owed should not exceed 30 percent of the credit limit in order to optimize a FICO score.5 Borrowers
should also refrain from making large purchases within sixty days of
applying for a loan in order to keep credit card balances low during
the scoring process. If a borrower has too much credit card debt or
too many unsecured loans, paying them off in full in one fell swoop
can potentially raise a score by seventy points. And, once those credit cards or credit accounts are paid in full, a prospective borrower
should keep them open. Closing too many accounts after they have
been paid off will reduce the borrower’s total credit limit. Decreasing
the number of accounts in effect decreases the aggregate credit limit,
and, without decreasing debt on accounts that are still open, results
in credit balance ratios that remain too high. If a borrower consolidates his debts, it’s better to use an installment loan from a bank to
112 Commercial Mortgages 101
pay off revolving debt balances while keeping these revolving
accounts open. Installment loans are viewed more favorably by commercial real estate lenders because they show that borrowers can pay
off a loan in regular installments over a set period of time, differentiating them from revolving credit cards that seem to have indefinite
balances. If a borrower chooses to close a credit card account, it’s
better to close accounts that are less than two years old. In general,
FICO scores are higher for borrowers who have older, active accounts
and lower for borrowers with relatively new accounts.

Collections and Delinquent Accounts

Collections and delinquent accounts (unpaid accounts that have not yet
been turned over to a collection agency) are major red flags for commercial real estate lenders. Collections are a result of failed attempts
by the original creditor to collect an outstanding debt. Any account
that becomes delinquent or is turned over to a collection agency, no
matter how small the debt is, can lower a FICO score by eighty
points. So whether it is a $100 medical bill or a $25 cell phone bill,
the account is deemed derogatory and negatively impacts the FICO
score. Extenuating circumstances that were unavoidable but that
resulted in adverse action against the borrower will in most instances
be overlooked by a lender if the borrower’s explanation is legitimate.
However, adverse accounts such as collections that appear to be inexcusable are much more difficult to tolerate. Collections are usually
not tolerated unless the borrower is currently disputing an account
that has been erroneously turned over to a collection agency.
However, lenders feel that there is never an excuse for letting an
account morph into a collection no matter who is at fault. No matter
how small or large the debt that was turned over for collection, it is
still a credit blemish that can tarnish a borrower’s creditworthiness.
These adverse accounts should be avoided at all costs or expunged
Financial Strength and Creditworthiness 113
from a borrower’s credit report as soon as they appear. As time passes, delinquent accounts have less and less impact on a FICO score,
so it’s paramount to settle the account as soon as possible

Lack of Credit

A borrower’s credit history accounts for 15 percent of his FICO score
and is the third most important indication of his ability to manage
debts responsibly over time.6 Less is not more when it relates to the
number of credit accounts. Having either too few or too many credit
card accounts can lower a FICO score. In a sense, when it comes to
optimizing a FICO score, it is all about creating the right mix of credit types. If a borrower doesn’t have any prior mortgage payment history, for example, it will be very difficult for a commercial real estate
lender to assess whether or not the borrower is capable of meeting
the monthly mortgage payments. However, even borrowers who are
minimalists should consider beefing up their credit history by having at least two to three revolving credit card accounts, a mortgage,
and an installment loan, such as an auto loan, or another extension
of credit that has been established at least one year. The lender is
essentially looking for a lengthy history of monthly payments that
demonstrates a borrower’s ability to manage a mix of revolving and
installment debt. Essentially, the lender will lack confidence in the
borrower’s ability to pay in a timely manner if the borrower has no
history. Borrowers who are debt free but have no credit or payment
history should not suddenly open several new credit card accounts all
at one time. This approach creates numerous inquiries that can
lower a FICO score.

Foreclosures, Bankruptcies, and Summary Judgments

In addition to credit scores, payment history, credit balances, and
length of credit history, lenders also look for past foreclosures, bank114 Commercial Mortgages 101
ruptcies, and summary judgments. A past foreclosure usually means
certain death for a borrower. His chance of ever getting loan approval
for a new loan is nil, unless there is some mitigating circumstance
that could explain the foreclosure. Foreclosures that are at least ten
years old may be another exception. As mentioned previously, commercial real estate loans are not listed on a borrower’s credit report,
so any past commercial mortgage foreclosures will not be immediately obvious to the lender. Other sources such as LexusNexus or
UCC filings may disclose foreclosures, but these sources are not reliable. Most borrowers own commercial properties or have the titles to
the properties vested in a distinct legal entity such as a limited partnership or corporation. These legal entities can be searched for past
foreclosures, as can the borrower’s individual name.
Bankruptcies can be either personal or corporate, and the lender
will want to know the reason and the nature of the bankruptcy. Credit
reports are not supposed to disclose bankruptcies older than ten
years or any adverse account information such as collections or outstanding unpaid debts older than seven years. But often bankruptcies
are difficult to remove and will stay with the borrower for quite a long
time. However, some lenders may allow bankruptcies if they have
been fully discharged and are at least seven to ten years old. But any
bankruptcies, such as Chapter 7 bankruptcies that are less than
seven years old, will be unacceptable to most lenders and will result
in denial of credit. In general, before a lender will excuse a bankruptcy, the borrower must demonstrate that he has reestablished
good credit from the time of the discharge to the date of the mortgage application. The borrower must also provide in writing a reason
for the bankruptcy that is acceptable to the lender.
Summary judgments, lis pendens, garnishments, and tax liens
must be paid in full or satisfied prior to or concurrent with the loan
funding. A summary judgment is an award by the court against the
borrower in a case that has not gone to trial. In other words, a sumFinancial Strength and Creditworthiness 115
mary judgment is an enforceable legal claim for damages or indebtedness against another. Lis pendens, Latin for “a suit pending,” is a
written notice that a lawsuit related to the title to real property or to
some interest in real property has been filed. All garnishments and
tax liens must be paid in full or removed from a borrower’s credit
report and from all public records before a lender will fund a loan.
Unless these encumbrances are removed, the lender cannot perfect
its first lien against the property. Even if they are removed or paid in
full to the satisfaction of the lender, the borrower must still furnish a
letter of explanation. In summary, summary judgments and liens are
headaches that should be dealt with immediately before they show
up on a credit report.
Perso.

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