FINANCIAL STRENGTH AND CREDITWORTHINESS

FINANCIAL STRENGTH AND CREDITWORTHINESS

Commercial real estate lenders base their decision to fund commercial real estate loans on two primary conditions; the
strength and consistency of the property’s cash flow and on the
financial strength and creditworthiness of the borrower. As previously discussed in Chapter 1, analyzing the strength and consistency of the property’s cash flow is referred to as property
underwriting, and analyzing the financial strength and creditworthiness of the borrower involves underwriting the borrower.
The process of underwriting the borrower is the topic of
Chapter 3, which includes a detailed discussion of financial
strength and creditworthiness and examines personal net worth,
liquidity, and free cash flow.

FINANCIAL STRENGTH AND CREDITWORTHINESS

Net Worth and Liquidity

Net worth on paper may look fairly impressive at first glance, but,
from the perspective of a commercial real estate lender, this opinion
of one’s worth is nothing more than wishful thinking on the part of
the borrower. Net worth is relative, and one should always be reminded that net worth on paper is entirely different from the borrower’s
true or actual net worth. Often we hear someone bragging about
someone else’s net worth, but what is net worth and what does it really mean? Personal net worth is the equity or residual interest in the
assets of a person or an entity that remains after deducting liabilities.
In other words, it is simply the difference between the total value of
all assets less the total of all liabilities. Net worth, also referred to as
owner’s equity, is found on the borrower’s balance sheet. Accounting
firms and accountants typically use the term “owner’s equity” in lieu
of “net worth,” though both really mean the same thing. In the definition of net worth the words “equity” or “residual interest” in the
value of an asset refer to capital. Whether the borrower’s capital is in
the form of cash only or in cash and appreciation is a question only
a balance sheet can help answer. Analyzing a borrower’s net worth
always begins with a review of a borrower’s balance sheet. Balance
sheets are a part of a set of personal financial statements usually prepared by the borrower or the borrower’s accountant. An audited
financial statement, or, specifically, the balance sheet, prepared and
audited by an accountant or a certified public accountant (CPA), is
usually preferred by lenders to a balance sheet prepared by the borrower. A set of compiled financial statements prepared by a CPA,
though not yet audited, is also acceptable by lenders. A balance sheet
prepared by an accountant or a CPA is much more reliable than one
prepared personally by the borrower because borrowers tend to
invariably overstate the value of their assets. That’s not to say that an
accountant can’t get it wrong, too, since much of the financial infor88 Commercial Mortgages 101
mation comes directly from the borrower. There are many other
errors made by borrowers that either overstate their assets or understate their liabilities, but the single most common error on nearly
every balance sheet that is not prepared by a CPA is inflated values.
A lender will question these values and in most cases adjust the total
value of all the assets down to a lower, more realistic figure.
Liabilities and debts, on the other hand, are usually not overstated
but are often understated or intentionally omitted, resulting in an
exaggerated net worth.

Assets

Let’s examine the asset side of the balance sheet, which is where
most of the errors and value exaggerations occur. Lenders often find
inconsistencies and ambiguous values that seem to have been pulled
right out of the air. There are many types of short-term and long-term
assets, both tangible and intangible. Short-term assets, also referred to
as current assets, generally include cash, marketable securities, receivables, inventories, prepaid expenses, and other assets, which are
expected to be converted into cash, sold, or used in the operations of
the business, usually within a year. Long-term assets, also referred to
as fixed assets, generally include real property and plant and equipment used in the operations of the business, which will be held for
many years. Tangible assets are assets that have physical substance,
such as land, buildings, real property, automobiles, manufacturing
equipment, and inventory. Intangible assets have value, like tangible
assets, but do not have physical substance; they include franchises,
patents, copyrights, trademarks, and goodwill. Aside from pointing
out the difference between short-term and long-term assets and tangible and intangible assets, we should mention one more distinction,
and that is the distinction between non–real estate assets and real estate
assets. Non–real estate assets and real estate assets are not subcateFinancial Strength and Creditworthiness 89
gories found on a balance sheet but are internal asset classes used by
commercial real estate lenders. The distinction between the two asset
classes helps the lender identify the primary source of a borrower’s
net worth, which is discussed later in this chapter.
Commercial real estate lenders are not like commercial bankers.
They don’t lend to businesses that are engaged in manufacturing,
production, or retail services that generate revenue from producing
or rendering goods and services. These types of businesses generally involve the ownership, use, and manufacture of different types of
non–real estate assets (excluding plant and equipment), both tangible and intangible and are integral to the operations and profitability
of the business. Non–real estate assets of an enterprise such as these
are of little value to a commercial real estate lender, since, after all,
the primary interest of a commercial real estate lender is to lend
money for the purchase or refinance of an income-producing property that produces cash flow, not for the purchase of special-use facilities that are owner-occupied. This distinction is important because
commercial real estate lenders understand real estate and real estate
only. Non–real estate assets, with the exception of cash, CDs, stock,
bonds, and marketable securities, used for or related to other types of
businesses are rarely used as collateral and often are excluded in calculating a borrower’s net worth. The issue of non–real estate assets
versus real estate assets in relation to net worth is especially relevant
when or if the value of the property securing the loan unexpectedly
falls below the loan amount. And if the borrower defaults on the
loan, resulting in a huge loss for the lender, how will the lender
recover the loss? This is where the true test of a borrower’s financial
strength comes into play, and that depends squarely on whether a
borrower’s net worth consists primarily of real estate assets or
non–real estate assets. Borrowers who have sufficient real estate
assets and who own other commercial properties are much stronger
than those that don’t and are less likely to default on the loan. The
90 Commercial Mortgages 101
presumption here is that there is ample equity in the real estate
assets (separate and apart from non–real estate assets), which can be
converted into enough cash to pay in full the loan that is in default or
at least cover the deficiency if the lender is forced to sell the property for less than the original loan amount. Conversely, borrowers who
have only non–real estate assets that cannot be converted to cash relatively quickly and that are integral to the operation of other businesses are more likely to default on the loan. Lenders doubt that
these non–real estate assets can be sold at their full stated value or
sold at all.

Non–Real Estate Assets

Non–real estate assets include both short-term and long-term assets
excluding real property, with the exception of land, plant, and equipment of an owner-occupied facility used in manufacturing and distribution (in the context of this discussion regarding non–real estate
assets, land, plant, and equipment are treated more as fixed capital
than real property). Examples of non–real estate assets include just
about any type of asset not classified as real property, such as cash,
stocks, bonds, marketable securities, account receivables, note
receivables, goodwill, inventory, prepaid expenses, tools, jewelry,
retirement accounts, automobiles, and equity in net assets of a partnership or subsidiary. The problem with most non–real estate assets
such as stock in a private corporation, trusts, equity in net assets of a
partnership or subsidiary, time shares, account receivables, or even
patents and trademarks is that their monetary worths are just mere
guesses, with no justification given for their assumed values. There
is no way for a commercial real estate lender to verify the veracity of
these stated values, and that’s why a balance sheet prepared by a CPA
is preferred to one prepared by the borrower. A lender is much more
likely to believe in the monetary values of non–real estate assets if
Financial Strength and Creditworthiness 91
they have been prepared by a CPA, since, after all, these values are
reported to the IRS. All of these non–real estate assets may be assets,
technically speaking, but to a commercial real estate lender they are
of little value as collateral for a commercial real estate loan. In reality, a lender has no use for these non–real estate assets because they
are difficult to liquidate and fall outside the expertise and understanding of a commercial real estate lender. A commercial real estate
lender understands real estate only and thus really and truly likes to
see real estate assets above all other asset classes on a borrower’s balance sheet.
As previously mentioned, lenders often exclude several non–real
estate assets from the calculation of net worth. The main reason that
they are often disregarded is that non–real estate assets are difficult
to liquidate and at best extremely difficult to value. In a commercial
real estate lender’s mind, these assets can be difficult to sell; even if
they can be sold, the lender will question how much cash will be
raised by the borrower in the event that the borrower needs to liquidate his assets to meet the obligation on a loan that was secured by a
property that failed to retain its value. So, then, which non–real estate
assets are worthy, and which ones are not? Following is a list of non–
real estate assets, which are separated into those assets excluded and
those that are included in the calculation of a borrower’s net worth:

Real Estate Assets, Cash Equity, and Market Equity

Owner’s equity, also referred to as net worth, is the residual ownership interest in the value of any asset after deducting its liabilities.
This definition of owner’s equity also applies to real estate assets. For
example, if a property is worth $5 million and there is a mortgage of
$3 million, the owner is presumed to have an owner’s equity or residual ownership interest in the value of the property equal to $2 million. Now if this property is the borrower’s only asset and assuming
there are no other non–real estate assets, such as cash, stocks, or
marketable securities, the borrower’s net worth is the same as his
owner’s equity of $2 million. In this situation, net worth and owner’s
equity are one and the same. From this point forward, the discussion
concerning owner’s equity and net worth is based on the assumption
that total net worth is no different from owner’s total equity in each
and every real estate asset.
Total owner’s equity or net worth is usually composed of both
cash equity and market equity. Depending on the ratio or balance of
cash equity to market equity, the lender’s net worth requirement will
vary. Let’s say a borrower’s net worth is $5 million, of which $1 million is in cash and $4 million is market equity. Market equity is the
difference between the current debt and the appraised value of the
property regardless of the original cost. For example, if an investor
Financial Strength and Creditworthiness 93
• IRAs, 401(k)s, pension
• Earnest money escrowed at title
company
paid $3 million for the purchase of an apartment complex and borrowed $2 million, his initial cash equity would be $1 million. But
suppose that, years later, the property appraises for $4 million and
the investor still owes $2 million; the investor’s market equity is now
$2 million, even though the investor had an original cash equity of
only $1 million. In this illustration, the investor’s market equity of $2
million is in reality a combination of $1 million in cash and $1 million in appreciation. Usually, after a year, lenders will allow the use
of market equity in lieu of cash equity if they agree with the market
values shown on the borrower’s balance sheet.
Now let’s say that the borrower wants to borrow $5 million for the
purchase of a retail shopping center. In this situation, the borrower’s
net worth of $5 million is equal to the amount the investor wants to
borrow, which means that it is sufficient to pay back the entire $5
million loan. However, lenders know that, no matter what happens,
the risk of losing the entire $5 million loan is unlikely because the
property will always retain some amount of value even if it is 100 percent vacant. Properties will always have residual land value along
with some salvageable value because of the improvements (building
fixtures, parking garage). Even if the lender has to foreclose on the
property and later sells it for 30 percent of its original value, the
lender will never face a 100 percent loss. So, in reality, the lender’s
potential loss is never 100 percent of the $5 million loan. A borrower’s net worth, therefore, does not need to be equal to the loan
amount. For example, suppose the investor pays $6.250 million and
borrows 80 percent, or $5 million. Two years later, the retail center is
hit hard by the downturn in the local economy due to the loss of a
major employer. The tenants cannot survive this downturn, and
eventually break their leases and vacate the retail center, leaving the
investor no cash flow to pay back the loan. The investor defaults on
the loan and the lender forecloses, taking back the property. One year
later, the lender finally sells the property for $3 million, or approxi94 Commercial Mortgages 101
mately $0.48 on the dollar (the original purchase price was $6.250
million). However, the original loan balance was only $5 million. The
lender therefore records a loss of $2 million (most likely this was a
full recourse loan, making the borrower liable for the lender’s loss of
$2 million).
As mentioned earlier, the borrower’s total net worth was $5 million, which is more than sufficient to cover the lender’s loss.
Remember that the borrower had $1 million in cash and $4 million
in market equity. In this situation, the borrower is liable for the
lender’s loss and has to pay the lender $2 million in cash. Since the
borrower has only $1 million in cash, the rest has to come from the
sale of one or more of the borrower’s properties to raise another $1
million in cash to cover the $2 million loss to the lender. In this
example, the borrower’s minimum net worth would have had to have
been at least $2 million (or 40%) of the $5 million loan to adequately cover the lender’s $2 million loss. But this is really cutting it close.
The lender would have taken a big risk if they had approved the $5
million loan based on a $2 million net worth. If the borrower’s minimum net worth of $2 million were in all cash, that would have been
acceptable to the lender, but if it was $500,000 in cash and the rest
in long-term assets, it is unlikely that the borrower would have been
approved for a $5 million loan on the basis of that mix of cash equity and market equity.
Lenders do not use a standard formula to calculate the minimum
net worth of a borrower, but a general rule of thumb is that net worth
should generally be equal to the loan amount. The minimum net
worth a borrower must have is about 50 percent of the requested loan
amount. In the foregoing illustration, the general rule of thumb
would have required that the borrower’s net worth be at least 50 percent, or $2.5 million of the $5 million loan request. But before the
borrower’s net worth can be considered sufficient, whether it is 50
percent, 60 percent, or even double the loan amount, it is important
Financial Strength and Creditworthiness 95
to first examine the borrower’s balance sheet and question those
assets that are often disregarded by most real estate lenders. The
review and examination of the balance sheet should result in an
adjusted net worth that excludes non–real estate assets, both intangible and tangible, as previously demonstrated in the Non–Real
Estate Assets section. It is not uncommon for a real estate lender to
lower a borrower’s net worth by 50 percent or even more. This is the
single most exaggerated part of a borrower’s financial statement. The
statements are not necessarily fraudulent, but exaggerations do put
into question the borrower’s truthfulness. An inaccurate representation of the borrower’s financial well-being does not bode well when
the lender is making a financial credit decision.

Cost Vs Market Value

Another concern for lenders is the issue of cost versus market value as
it relates to real estate assets. Are the values listed on the asset side
of the balance sheet stated at their original cost, or are they stated at
market or appraised value (this discussion does not include non–real
estate assets, since their values, whether cost or market, are usually
not factored in when lenders are estimating a borrower’s net worth)?
Which does the lender prefer? That depends on whether the asset is
a recently acquired asset or one that has been owned for several
years. The general rule is that if a real estate asset has been owned
for less than one year, it is best to state the value at cost plus any capital improvements to truly reflect the borrower’s cash cost. Often a
borrower will have had the property reappraised within the first year
of ownership, which may or may not result in a value significantly
higher than the original purchase price. If the appraised value came
in significantly higher, then the borrower will most likely boast of
this new value and will want to show his newfound net worth on his
balance sheet. However, lenders prefer that these properties be sea96 Commercial Mortgages 101
soned for at least a year before they will start using the appraised values in determining a borrower’s net worth. The problem with
appraised values, especially those estimated within less than one year
of ownership, is that the value estimate is based on pro forma figures, which may have not yet been realized. In other words, the actual cash flow has not yet stabilized, and if the property has to be sold,
especially under pressure because of a borrower’s inability to pay off
an unrelated loan, it is likely to bring in a price far below the
appraised value.
Even if the borrower has owned the properties for years and is
using current market values, the lender may still question whether
they are really worth the values estimated by the borrower. How were
these values estimated? Does the borrower have recent appraisal
reports to support these values, or did the borrower capitalize the
NOI at some market capitalization rate to derive their values?
Borrowers tend to overstate property values, bringing into question
the borrower’s overall net worth, which is why these values must be
verified. If the property values cannot be verified, the lender will just
start hacking away at the values using their own best estimates,
resulting in a final value estimate that will no doubt lower the borrower’s net worth. When in doubt, it is always best to instruct the
borrower to list real estate assets at their original cost if at all possible; if the market values listed are justified, be prepared to defend
them by providing either the property’s most recent P&L statement
or a copy of the most recent appraisal report (preferably dated within the past year), along with the balance sheet.

Pre-Funding Liquidity

Pre-funding liquidity simply refers to the borrower’s level of liquidity
prior to funding the loan. Use of the term is essentially a definitive
way to distinguish the borrower’s overall level of liquidity from the
Financial Strength and Creditworthiness 97
borrower’s post-funding liquidity and nothing more. Liquidity is the
single most important quality of a creditworthy borrower. Liquidity
refers to the borrower’s ability to convert readily available short-term
assets into cash or U.S. currency in a timely manner, usually within
a few days. Unlike long-term assets, which can take months or years
to sell, liquid assets can be converted to cash within days and are the
most sought-after assets on a balance sheet. Liquid assets include
both cash and noncash assets and therefore are included in the calculation of net worth. Even though net worth is important, commercial real estate lenders also want to know how much of that net worth
is liquid. Liquidity is a measure of the borrower’s ability to withstand
financial hardship. The portion or percentage of cash and short-term
assets that can be converted into cash within a few days is commonly referred to as a liquidity ratio. Standard liquidity ratios usually
equal 10 percent or 20 percent of the borrower’s net worth. Examples
of liquid assets include the following:
Cash assets
Checking and savings accounts
Money market accounts
Certificates of deposits (CDs)
Earnest money held in escrow
Trust accounts (only if the trust is a guarantor and if it is a
family trust; restricted and charitable trusts cannot guarantee debt)
Capital replacement reserves
Marketable securities (noncash assets)
Stocks
Bonds
Mutual funds
98 Commercial Mortgages 101
Short-term assets that are often mistaken for liquid assets
include individual retirement accounts (IRAs); employer retirement
accounts, such as 401(k)s; pensions; and other vested retirement
funds. Retirement accounts are disqualified as liquid assets for two
reasons. The first problem is that there are significant early-withdrawal penalties and income taxes if funds are withdrawn prematurely, which effectively deters a borrower from using the cash. The
second is that IRA accounts and 401(k)s are usually protected from
liquidation or seizure in a personal bankruptcy, rendering them inaccessible to any creditor. Also, if a borrower is essentially retired and
is drawing on these retirement funds, lenders consider them as
sources of income only and not as sources of cash to repay any
debt. If the borrower has significant income from a salaried job or
from real estate investments, only then will the lender consider
the IRAs as a liquid asset, but this is not often the case. In summary, pre-funding liquidity should equal approximately 10 percent of a
borrower’s total net worth. Keep in mind that this percentage ratio is
just a general rule of thumb. Some lenders may want to see that figure as high as 20 percent

Post-Funding Liquidity

In a refinance, depending on whether the loan involves cash out to
the borrower, post-funding liquidity does not differ from
pre-funding liquidity. However, if the loan is for the acquisition of a
property and is not a refinance, post-funding liquidity will decrease
by an amount equal to the dollar amount of the down payment. Postfunding liquidity is the amount of cash the borrower has remaining
after the loan has been funded. Whether the loan is for a refinance
or a purchase, there are usually financing and closing costs, fees, and
down payments involved that result in a “Cash (from) Borrower” figure on the purchaser’s side of the settlement statement. This “Cash
Financial Strength and Creditworthiness 99
(from) Borrower” figure is the actual amount of cash a borrower
must bring to the closing. So it is essential that the estimated settlement charges and the down payment be excluded from the calculation of a borrower’s post-funding liquidity. In the lender’s eyes, it is
not enough just to prove liquidity for the purpose of consummating
the transaction; it is a litmus test that demonstrates financial wherewithal and staying power. For example, if it takes every penny the
borrower has to fund the loan, leaving the borrower with no cash
whatsoever, and then all of a sudden there is an unexpected major
breakdown or necessary repair at the property or, even worse, damage from hail or wind, where will the borrower get the money to
remedy the problem? If there is storm damage, how will the borrower pay the required $5,000 or $10,000 deductible? If the
borrower cannot meet the deductible, the insurance company may
not pay the claim. Without sufficient cash reserves, the borrower will
be unable to make repairs or pay the insurance deductible, which in
turn may result in loss of occupancy and cash flow. And what about
a sudden loss of occupancy that reduces the income so significantly
that there isn’t enough cash flow to make the monthly mortgage payment? For this reason, lenders require post-funding liquidity of some
predetermined amount. But how much is enough?
In general, post-funding liquidity should equal at least six
months’ worth of monthly debt service, if not more. Some lenders
actually require twelve months’ worth of debt service; it depends on
the lender’s credit policy, which does change from time to time to
reflect current economic conditions. Monthly debt service is another
way of referring to the monthly principal and interest (P&I) payments. For example, six months’ worth of monthly principal and
interest payments of $10,000 will require at least $60,000 in postfunding liquidity ($10,000 x 6 months = $60,000). Post-funding liquidity less than $60,000, in this example, is inadequate and may
result in the denial of the loan.
100 Commercial Mortgages 101
The minimum level of post-funding liquidity can also be calculated by multiplying the loan amount by 10 percent. For example, a
loan of $2 million will require at least $200,000 in post-funding liquidity, preferably in cash ($2,000,000 x .10 = $200,000). However,
for a loan of this size, 10 percent may be too high. In fact, the 10 percent rule results in a significantly higher post-funding liquidity
requirement of $200,000 than does the six-month rule, which
results in a requirement of $60,000. If the difference between the
two methods is significant, as in this example, a lender may split the
difference or just use the lower value of the two. This is a judgment
call by the underwriter and depends on other underwriting factors,
such as strength in the property cash flow and loan to value.
However, if a borrower can demonstrate this kind of financial
strength, there is a 90 percent chance that a lender will look favorably on the loan request and drop the 10 percent rule.

Lender’s Calculation of Net Worth and Pre-Funding and
Post-Funding Liquidity

Commercial real estate lenders are skeptical by nature and often
project a negative outlook, which explains why they are extremely
conservative. They routinely assume the worst-case scenario in all
transactions and factor in contingencies. It is for this reason that
lenders often challenge asset values enumerated on a balance sheet.
If asset values declared by the borrower are suspect, then liquidity
and net worth may be suspect, as well. Borrowers, whether intentionally or not, tend to overstate asset values or simply misrepresent
their net worth. Lenders, on the other hand, embrace their own opinion of value regarding liquidity and net worth and as a consequence
take the liberty of calculating a completely different set of values.
Lenders modify liquidity and net worth by either reducing the assets’
underlying value or excluding them from the balance sheet altogethFinancial Strength and Creditworthiness 101
er. Figure 3-1 is an example of an unaudited balance sheet prepared
by the borrower, absent any supporting financial schedules and
notes. Without supporting documentation, such as real estate schedules, financial notes, and tax returns, real estate lenders are often left
in the dark and are forced to make undocumented assumptions
regarding not only the origin of these asset values but their reliability, as well. If there were a way to independently verify the accuracy of
these asset values, lenders would certainly take that approach, but
often that is neither practical nor possible. It is this skepticism that
compels lenders to closely examine each line-item asset and to determine whether or not to exclude a particular asset from their own estimate of liquidity and net worth. This underwriting exercise or, more
specifically, modification by the lender is not an attempt to undermine the borrower’s ego but is simply a stress test intended to accurately reflect the borrower’s true liquidity and net worth. The following discussion demonstrates how lenders calculate net worth and prefunding and post-funding liquidity.
The sample balance sheet illustrated in Figure 3-1 includes two
columns, one with an unadjusted net worth and one with an adjusted or revised net worth. The second column, labeled “Lender’s
Adjustment,” is nothing more than a duplication of the first column
and does not represent a standard balance sheet. As illustrated in the
first column, the borrower’s unadjusted net worth is $8 million.
However, the second column indicates an adjusted or revised net
worth equal to $4,301,500. The adjusted net worth is the result of the
lender’s scrutiny of individual line-item assets. When the relevancy
or value of these assets are in doubt and the borrower cannot provide
a satisfactory answer or supporting documentation, the assets are
simply excluded from the calculation of the borrower’s net worth.
As demonstrated in Figure 3-1, the lender begins by crossing out
two short-term assets, accounts receivable and a life insurance policy.
Receivables in general are assets representing the claims that a bor

rower has against others. In particular, accounts receivable are extensions of credit to customers for either the purchase of merchandise
or the rendering of services. Accounts receivable are not supported
by “formal” or written promises to pay and are totally at risk. In other
words, an account receivable represents the dollar amount a borrower claims that he or she is owed by a third party, whether an individual or company. Though these types of assets are transferable, commercial real estate lenders often consider them worthless. The problem is that a certain percentage of the receivables are never collected.
Also, receivables are not secured. Instead of trying to guess at the
probability of repayment, a lender will just dismiss this asset altogether. The cash value of a life insurance policy is usually a negligible amount of money, and policies are rarely cashed in by borrowers,
even in bankruptcy.
Moving down the balance sheet, the lender identifies five more
questionable long-term (fixed) assets and begins by eliminating notes
receivable. Notes receivable are long-term loans or claims against oth-

ers, usually supported by “formal” or written promises to pay. These
may or may not be negotiable instruments depending on such factors as the terms, form, and content of the note. An example of a note
receivable would be a seller note or personal loan to a third party. It
is also important to note that these types of loans or claims may not
be secured, putting repayment of the loan at risk. In the case of a seller note, often referred to as seller financing, the borrower may have
secured his personal loan by placing a lien against the land or building. Though the lien may protect the borrower from loss, it does not
necessarily guarantee payment of the debt. Whether or not note
receivables are secured, repayment is not guaranteed and can take
years. It is for this reason that lenders often exclude notes receivable
from the calculation of net worth.
Investments in partnerships, businesses, or other non–real estate ventures are very difficult to liquidate. They are also very difficult to value
by a lender. A borrower may say that he invested $750,000 in cash
and list it as an asset, but the money is most likely already capitalized, so the borrower has no way of withdrawing the original cash
investment until the company authorizes a cash distribution or stock
offering. But, until then, a lender will usually exclude these types of
assets.
Oil and gas interests are complex assets requiring the use of special accounting rules. Like other long-term assets, the basis for
accounting for natural resources, such as timber, coal, oil, and gas
deposits, is primarily cost. Most likely, any cash investment made by
the borrower in an oil and gas venture is or will be amortized as long
as the borrower remains vested. Liquidating this interest may be difficult, if not impossible, which is why real estate lenders consider
these types of assets worthless.
Time shares are difficult to sell and are usually worth only a fraction of the original cost. Time shares also come with ownership
expenses, such as maintenance fees and administrative costs, which
106 Commercial Mortgages 101
lenders would rather do without. Assets such as time shares or vacation co-ops provide little security for the repayment of a loan, which
is why lenders overlook this asset, as well.
Goodwill is an intangible asset that represents certain rights and
privileges associated with a brand name or franchise. Goodwill is a
measure of value in a business in excess of its quantifiable value or
identifiable assets tied to cash flow, equipment, machinery, and
inventory. Because of the uncertainty involved in estimating the
goodwill of a business, goodwill is normally recorded only when a
business is acquired by purchase. Lenders regard goodwill as nothing more than a premium, relevant only to the borrower, which is
why this asset is dismissed, as well. Other assets ignored by the
lender include personal property such as automobiles, boats, guns,
art collections, furniture, and jewelry. These assets are rarely liquidated to repay a loan; if they are, they fetch only nickels on the dollar. Confiscating personal property is futile and produces very little
cash for the lender.
As illustrated in Figure 3-1, a total of twelve questionable assets
were disqualified and excluded from the calculation of net worth. In
summary, the overall adjustment by the lender results in a decrease
in the sum total of all assets by $3,698,500, which in turn results in
an overall decrease in net worth by $3,698,500. Assuming no change
in liabilities, net worth declined nearly 50 percent, from $8,000,000
to $4,301,500.
Liabilities in this example are unaffected; in reality, liabilities are
rarely adjusted by the lender. The lender’s adjustment to the borrower’s balance sheet results in a lower net worth of $4,301,500, not the
$8,000,000 indicated by the borrower. Since a borrower must have
at least a net worth of 50 percent of the loan amount, it is possible
that the borrower could get approval for an $8,603,000 real estate
loan on the basis of the lender’s adjusted net worth valuation of
$4,301,500 ($4,301,500 ÷ 0.50 = $8,603,000).
Financial Strength and Creditworthiness 107
Liquid assets are indicated by asterisks located beside each asset
category listed in the short-term asset section of the balance sheet. As
illustrated in Figure 3-1, there are seven short-term assets identified
as liquid: earnest money deposit, checking accounts, savings
accounts, certificates of deposit (CDs), stocks, bonds, and mutual
funds. On the basis of these seven assets, total pre-funding liquidity
is estimated to be $2,727,000. Assuming a minimum down payment of 20 percent, the borrower will need at least $1.6 million in
pre-funding liquidity for an $8 million loan ($8,000,000 x .20 =
$1,600,000). The borrower’s estimated level of pre-funding liquidity
is more than enough to cover the down payment and in fact, exceeds
the down payment by $1,127,000 ($2,727,000 – $1,600,000 =
$1,127,000). This excess amount of pre-funding liquidity over and
above the down payment is the amount available for post-funding
liquidity. In this example, post-funding liquidity is estimated to be
$1,127,000, which is invested in stocks, bonds, and mutual funds (all
of the cash was used for the down payment). As discussed earlier in
this section, post-funding liquidity must usually equal either 10 percent of the loan amount or approximately six months’ worth of
monthly payments of principal and interest. Assuming an interest
rate of 6.5 percent and amortization of 30 years, the monthly payment of principal and interest for an $8 million loan would be
$50,565; six months’ worth of monthly principal and interest payments would be $303,293 ($50,565 ~ 6 months = $303,392). Ten percent (10%) of the loan amount is $800,000 ($8,000,000 x 0.10 =
$800,000). As demonstrated, both estimates are well below the borrower’s actual post-funding reserve of $1,127,000. In this example,
post-funding liquidity of $1,127,000 exceeds the lender’s maximum
post-funding liquidity requirement by at least $327,000 ($1,127,000
− $800,000 = $327,000).
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
Thank you and consider reading Types of Commercial Real Estate Lenders

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