Commercial Real Estate Loans are for specific construction or development projects. The small percentage of unsecured credits to substantial companies in the real estate development business is the sole exception of note. Permanent financing of completed stabilized real estate projects s also outside of the usual area of concentration by commercial lenders because there is an absence of matching funding sources. Real estate projects financed by commercial lenders usually involve the conversion of raw land into developed land and/or the conversion of developed land into 1- to 4-family residential property, apartments, condominiums, hotels, office buildings, shopping centers, warehouses, or structures for other commercial uses.
The risks facing the real estate construction lender encompass a chain of value. What is the value of the land? What is the cost of construction? What is the value of the completed project? What is the source and likelihood of long-term takeout financing? To answer these questions, lenders depend upon three sets of information; Borrower, contractor, and subcontractor data; project and area-specific plans and projections; and appraisals and feasibility studies.
Banks financing real estate projects outside of their service area(s) are presumed to be engaging in a riskier than normal practice. Lending staff is less familiar with the players and the characteristics of areas outside of the bank’s service area. Distance also makes it more difficult to monitor the real estate projects. When significant dollars are invested outside of the bank’s delineated assessment area, management should be prepared to show that the bank is primarily targeting and servicing local markets. To avoid attracting regulatory scrutiny under the Community Reinvestment Act (CRA), the record should show that the bank is aware of local credit needs and striving to meet the needs of local communities. Management might defend their knowledge of local conditions by evidencing their expertise in a niche that is not being otherwise served by the competition.
Financial Capital Funding Group
We provide the following Services:
- Mezzanine/Equity Capital
- Working Capital for Business
- Funeral Homes Financing
- Church Financing
- Private Money Funding
- Construction Refinancing
- Development and Expansion
- Bridge Loans, Private Equities, Takeout Const. to perm
We specialize in small commercial loans
from $100,000 – $300,000,000
A common purpose of bank term loans is for a borrower to finance the acquisition of property, plant. and/or equipment finance since the credit decision would be based upon the general creditworthiness of the borrower. It is also useful to exclude from the category of equipment finance term loans where the security interest in the PP&E is integral to the decision to lend. Much of equipment finance is done in the form of leasing which is covered in the following section.
It is often the case that a borrower equipping a new plant or expanding an existing one will purchase the PP&E from multiple vendors. To accommodate this, banks may provide a short-term, nonrevolving credit line. The borrower should provide the bank with any required down payment and with the invoices for the goods. The bank should pay the vendors directly and simultaneously record a security interest in the new PP&E. This will avoid any conflicts over possible purchase money security interests in the property from the manufacturers and assure that the loan proceeds are used as intended. At the maturity of the credit line, the outstanding amount will be rolled into a term loan.
Valuing the Equipment
Unfortunately, it is not a simple thing to value the equipment being financed. While paying the invoices permits a certain confidence in defining the costs of acquisition of the PP&E, that cost is not the same thing as value. Everyone is familiar with the drop in the value of a new car as soon as the buyer drives it off the dealer’s lot. It is no different with PP&E. The bank’s analysis should be focused on the value of the equipment as collateral, not its cost. This, the costs of preparing the PP&E for sale and selling it must be deducted from the likely proceeds of that sale in order to define the PP&E’s value as collateral.
Highly specialized equipment presents a challenge. By its very nature, the market for it will be limited. In addition, the circumstance where the bank wishes to dispose of the equipment (i.e., following a default by an obligor) may have occurred because of negative conditions in the industry segment as a whole. Thus, anyone who could use the equipment may be experiencing stress similar to that of the borrower and want no part of it.
Structuring the Transaction
It is often useful to look at an equipment finance transaction from the point of view of the borrower. Although not a sophisticated form of analysis, many borrowers calculate their “payback period” when considering the acquisition of capital goods. The payback period is the answer to the question how long will it take me to earn back the cost of the equipment? There should not be a great divergence in the total tenor of the equipment loan and the payback period.
Scheduling amortization for an equipment loan is challenging. The equipment does not typically lose value in a straight-line fashion over time. Rather, equipment (just like cars) tends to lose value quickly initially, them more slowly until the residual or scrap value is reached. The economic benefit of owning the equipment, however, tends to be fairly even over time. Thus, there is often a kind of natural mismatch that may cause the outstanding amount of the loan to exceed the value of the equipment. This, of course, leaves the bank in an unsecured position.
To counteract this, amortization can be front-end loaded. Alternatively, a large down payment may be required. It is rare to have the amortization back-end loaded (such as in a mortgage). A logical (although not frequently used) method is to mandate an amortization schedule that maintains a constant loan-to-value ratio. Having sufficient certainty about the value of the equipment over time is rare, which makes this sort of amortization schedule difficult to define.
In the end, banks often settle for simply having even principal payments over the life of the loan. The rationale is that while the loan-to-value ratio will worsen in the early periods, those are the times when there is the least uncertainty. The loan-to-value ratio will generally be improving as the second half of the loan becomes due to compensate for the greater uncertainty associated with periods further in the future.
Covenants for an equipment loan are not greatly different than for any other type of term loan. Because the loan is structured to rely more on the value of the equipment versus the financial condition of the borrower, there is often pressure to minimize financial covenants. Borrowers may ask only for “on demand” or bare necessity” financials to be required. This pressure should be firmly resisted when it comes to informational covenants (financial statements, etc.). With financial covenants, there may be more room for negotiation.
A covenant that is often improperly overlooked is the inclusion of a requirement for a minimum amount of maintenance capital expenditures (i.e. specifying a maximum amount for capital expenditures seems to come more naturally to lenders). The borrower may want to run the equipment into the ground if times are tough enough, and the bank will have to see to it that the value of its collateral is not damaged in this fashion.
It should go without saying that insurance on the equipment is necessary. The bank must be named as loss payee. The maintenance of adequate insurance needs to be confirmed on a regular basis.
Leasing is the most common form of equipment finance. A lease is an agreement by at least two independent parties that one will use the PP&E of the other in exchange for the payment of rent. The party using the equipment is the lessee; the party owning the equipment is the lessor. The concept of “ownership” is a little slippery in leasing. The lessor is the one who holds the title documents. Either party may have the economic risk or benefit of ownership. A second slippery concept in leasing is rates of interest. Many leases do not make reference to a rate of interest. Yet because one party is making a stream of payments to another who had a cost of providing the goods being used, every lease has an implicit rate of interest (rate of return, if you prefer) within it.
Capital or Operating Leases
Leases are either operating leases or capital leases. The primary distinguishing characteristic is whether the lease transfers the economic risk or benefit of ownership to the lessee. The four tests of this quality made at the start of the contractual relationship are as follows:
- The lease transfers ownership of the property from the lessor to the lessee by the end of the lease
- The term of the lease is three-quarters or more of the economic length of life of the goods being leased
- There is a bargain purchase option available to the lessee
If any of these four tests apply, the transaction is a capital lease from the point of view of the lessee. For the lessor, in addition to one of the foregoing four tests, two other characteristics must apply. They are:
- The amount of future expense that the lessor must incur is known or estimable
- There is at least a reasonable likelihood that the minimum amount of lease payments will be collected.
If this is the case, then it is a capital lease from the point of view of the lessor. For either lessee or lessor, any lease that is not a capital lease is an operating lease. Borrowers often prefer operating leases because while the future rental payments on all operating leases summed together must usually be described in a footnote, the lease does not appear on the balance sheet. If it is a capital lease, then the lease will appear on the balance sheet. Operating leases are by far the most widely used form of off-balance sheet financing. Another reason why leasing is popular is that is provided, in effect, 100 percent financing for the cost of the PP&E in use. Finally, because of the tax benefits to owners, lessors will often provide a reduced rate of interest to lessees compared with the interest rate that the lessees would have to pay by borrowing directly and buying the PP&E for themselves.
There are three kinds of capital leases: (1) sales type, (2) direct financing, and (3) leveraged. The sales type is usually the one that an auto dealer offers. In any case, most banks do not provide this form of leasing. a direct financing lease is very much like a loan. Leveraged leases add a third party to the contract, one that is providing non-recourse debt financing.
Bank Leasing Characteristics
A bank may acquire PP&E for the purpose of leasing it. In general, the lease should be ready to go before the purchase is made — banks should not speculatively purchase PP&E. The leases should be full payout net leases. A full payout lease is one where the payments, tax benefits, and residual value of the PP&E equal or exceed the cost of acquiring and financing it. A new lease is one where the cost of maintaining, servicing, insuring, repairing, etc., the PP&E are borne by the lessee.
CEBA leases are limited to 10 percent of the bank’s consolidated assets. Each such lease must be for a period of not less than three months.
Banks are required to dispose of leased assets as soon as practicable after they come back into possession of the PP&E either through the expiry of the lease or through nonperformance of the lessee. The period for disposal must not exceed five years unless explicit permission has been granted (by the appropriate regulatory authority) for a five-year extension.
For direct financing leases, the bank must depend upon the credit worthiness of the lessee in the same fashion that it would for a borrower. Because the residual value of the PP&E at the end of the lease term is often crucial, the nonguaranteed portion of the residual value of the PP&E may not exceed 25 percent of the acquisition cost. This is essentially a hedge by which the bank-lessor defends itself from getting stuck with a PP&E that cannot be sold for the anticipated amount.
This form of leasing simply adds a nonrecourse lender to the leasing transaction. Rather than putting up all the money itself, the lessor borrows 50-80 percent of the cost of acquiring that PP&E. The arranged loan is on a nonrecourse basis but is coupled with an assignment of rents and first priority security interest in the PP&E. In effect, the lessee has been substituted for the obligor in the transaction as the lender looks to the rental stream and the equipment for repayment, not to any additional amounts from the normal obligor. The lessor retains the tax benefits of ownership, the lessee receives 100 percent financing at a reduced cost, and the lender has a secured loan.
A bank can act as either lessor or lender in a leveraged lease. Note that the structure of the transaction does not require much of the lessor. In fact, it is often the case that the lessors are SPEs with only a nominal existence outside of the specific transaction.
This form of finance is complicated, has complex documentation, and requires expertise. Accordingly, the regulators will pay particular attention to policies, procedures, and controls in the leasing area of a bank if it is engaging in leveraged leasing activity.