Understanding Commercial Bank Credit: A Quick Guide for Business Owners and Real Estate Investors
Understanding Commercial Bank Credit: A Quick Guide for Business Owners and Real Estate Investors
Bank financing plays a critical role in fueling business growth, supporting cash flow and working capital, and real estate development. As a business owner or real estate investor and developer, understanding how banks evaluate loan applications can be highly useful in your quest for financing. This guide provides an overview of the types of commercial loans available, key underwriting requirements, and how borrowers can best position themselves for approval.
Types of Commercial Loans
Banks offer a variety of loan products tailored to different business needs. Some of the most common include:
1. Term Loans
Used for business expansion, equipment purchases, or real estate acquisition.
Amortized over a fixed period with stated terms for repayment of principal and interest.
Can also be used to refinance existing loans or mortgages, or debt consolidation to enhance cash flow.
2. Business Lines of Credit
Revolving credit facility that allows businesses to draw funds as needed, up to a set limit.
Ideal for managing cash flow fluctuations associated with timing variations of the business’s operating cycles, covering short-term expenses, and seasonal cash.
3. Commercial Real Estate Loans
Financing for purchasing, developing, or refinancing commercial properties.
Typically structured as mortgages with loan terms ranging from 5 to 25 years.
Many include balloon payment maturities within the amortization term.
4. Construction Loans
Short-term financing, usually up to 24 – 30 months, to fund the construction or development, including site infrastructure, of commercial or residential properties.
Usually interest-only during the construction phase, and converted to permanent financing, mini-permanent term, or refinanced as “take-out” by another lender or secondary market.
5. SBA Loans
Government-backed loans designed to support small businesses generally with limited capital, or for fixed assets purchases with lower down payments and longer repayment terms.
Includes programs like SBA 7(a) loans for working capital, growth, and expansion, and SBA 504 loans for owner-occupied real estate, plant, machinery and equipment.
Key Requirements for Credit Underwriting
Banks assess multiple factors when evaluating loan applications. Key underwriting requirements include:
1. Creditworthiness
Banks review personal credit scores and prior business loan payment history to assess risk.
A key and vital metric for considering any commercial credit application.
2. Business Financial Statements and Supplementary Information
Lenders typically require financial statements, tax returns, and cash flow projections.
Strong revenue, profitability, and liquidity, along with consistent cash flows, enhance eligibility.
A healthy balance sheet should show strong liquidity, working capital, equity, and manageable leverage.
Supplemental documents may be required, especially for larger transactions:
Businesses: A/R and A/P aging schedules, interim financial statements
Contractors: Work-in-process reports, primary job contracts
Real Estate: Leases, rent rolls, tax receipts
Construction & Development: Site/building plans, specifications, budgets, and resumes of the general contractor, builder, and project manager
Individuals: Personal financial statements, tax returns, and bank/investment statements
3. Debt Service Coverage Ratio (DSCR)
DSCR measures a borrower’s ability to repay the loan from operating income.
A DSCR of 1.25 or higher is typically preferred by lenders.
Banks may also evaluate global cash flow from affiliated entities.
For middle-market borrowers (revenues >$10MM), UCA (Uniform Credit Analysis) may be applied.
4. Collateral
Many commercial loans require collateral such as real estate, equipment, accounts receivable and/or inventory.
The value of the collateral should align with the loan amount, and loan term align with the economic life of the pledged asset(s).
5. Management
Lenders evaluate the borrower’s experience and capabilities of the management team.
Industry expertise increases and proven track record further enhances confidence in repayment ability.
Preparing and Presenting a Strong Loan Request
To increase the likelihood of loan approval, borrowers should:
1. Organize Financial Documents
Ensure that financial statements are current and accurate
For sizeable loans or credit lines (particularly for middle-market businesses and contractors), consider GAAP-prepared statements.
Maintain accurate interim financials—whether internally prepared or accountant-reviewed.
Be prepared to submit tax returns and bank statements as well.
2. Pay Attention to Credit Histories and Scores
This applies to both personal and business credit. Avoid maxing out credit cards or HELOCs.
Business owners: Maintain good vendor/supplier relationships by paying on time.
Contractors: Maintain strong relationships with bonding companies.
Monitor credit reports regularly and address issues in advance.
Ensure public record searches are clear of suits, judgments, tax or mechanic's liens - open items may raise red flags.
3. Demonstrate Cash Flow and Balance Sheet Strength
Show consistent and sufficient cash flow to cover loan payments.
Prepare a detailed cash flow forecast with realistic assumptions.
Maintain strong working and equity Capital and avoid overleveraging.
4. Develop a Comprehensive Loan Proposal
Clearly outline how the how the loan will be used and the expected financial impact.
Include data to support your assumptions and a well-articulated repayment plan.
5. Build Relationships with Lenders
Engage with commercial bankers early to understand lending criteria.
Establish a history with a financial institution to improve credibility.
Final Thoughts
Understanding commercial bank credit is key to securing the right financing for your business or real estate project. By knowing the different loan options, meeting underwriting requirements, and presenting a well-prepared loan request, borrowers can enhance their chances of obtaining the funding they need in a timely manner.
Understanding Borrowing Cause vs. Loan Purpose
One often overlooked but crucial distinction in financing is the difference between the Borrowing Cause and the Loan Purpose.
Loan Purpose: How the loan proceeds will be used.
Borrowing Cause: The underlying financial or business condition that creates the need for financing.
Understanding both helps you better articulate your case to lenders. I’ve observed many instances where profitable businesses faced cash flow difficulties. These situations, while seemingly counterintuitive, underscore the complexity of financial management.
Example: Saying “I need cash to cover payroll and taxes” may raise red flags about financial mismanagement. But if the cause is increased working capital due to growth, and the funds will cover short-term obligations during this period, lenders will likely view your loan request more favorably. Pinpointing the borrowing cause will lead to the appropriate loan amount, loan facility and credit structure.
Likewise, with real estate developers and investors, market conditions often present investment opportunities with attractive returns to capital. In markets like the NY metro area, the healthcare industry is among the most significant and fastest growing sectors. Many investors are capitalizing on this trend with medical office developments and acquisitions. Banks, in turn, are actively supporting well-structured projects led by experienced developers.
Concluding Statement
Aligning the Borrowing Cause and Loan Purpose with the proper credit structure ensures smooth continuity of business operations, and access to capital for real estate ventures. Your accountant or financial advisor will often assist with your capital and funding requirements, but I can offer a deeper dive in collaborating with you and your financial professionals in evaluating your Cash Flow Drivers, UCA Cash Flow, and Trend Analysis* of historical performance with financial projections collectively to achieve the optimal financing for growth and success.
*Cash Flow Drivers, UCA (Uniform Credit Analysis) and Trend Analysis will be covered under future articles.
