Best Practices for CRE Lender to Mitigate Credit Risk

David Cohn
Nov 8, 2022
Credit Score

Suppose you consider applying for a commercial real estate (CRE) loan to finance a project.

In that case, it's essential to understand how lenders mitigate credit risk to put your best foot forward.

Of course, not all lenders have the same parameters, but many tend to focus on the same areas when reviewing a loan application.

By understanding how they think, you can prepare the proper documentation, projections, and overall narrative to increase the chances of approval and negotiate the best terms.

Understanding credit risk

Credit risk refers to the possibility of a lender losing money because a borrower fails to meet contractual obligations or repay a loan.

So naturally, the lower your credit risk, the more likely banks, and other traditional CRE lenders will approve your application.

This is why banks go to great lengths to review a borrower's financial history and overall financial health to quantify the risk that the borrower might default on the loan.

While there is no way to predict precisely who will trigger a default event later on, correctly measuring and managing credit risk lessens the severity of a loss for a lender.

As a borrower, it would be in your best interest to demonstrate your and your business's ability to service all future payment obligations (both principal and interest).

Lenders use measurement tools designed to quantify credit risk and employ mitigation strategies for minimizing loan loss should a default occur.

How lenders manage credit risk

Credit risk management involves multiple steps, but these steps can be classified into two categories: measurement and mitigation.

Measurement of credit risk

Lenders use proprietary risk rating tools, which differ depending on the lender or jurisdiction. In addition, there are different tools for personal and business borrowers.

In personal lending, creditors will look into the borrower's financial situation. They will look into matters like:

  • How is your credit score looking?
  • Do you have any other assets?
  • What are your other loans and responsibilities?
  • What is your income relative to all of your obligations?

Most personal lending agreements require some form of collateral or personal guarantee.

In contrast, commercial loans are considerably more difficult. After all, many business clients borrow more money than personal borrowers.

Therefore, measuring a commercial borrower's risk rating requires a combination of qualitative and quantitative approaches.

Qualitative risk assessment categories include the following:

  • Assessing the business—what sets it apart from others in its industry and how management plans to make it grow.
  • Reviewing the management team and the ownership (if the company is privately owned). One will take the reputation of the management team and the owner's credit scores into account.
  • Evaluating the borrower's overall market position and comparable companies in the same industry

A financial analysis comprises the quantitative part of the credit risk assessment. First, lenders scrutinize various performance and financial ratios to assess a borrower's overall well-being.

Then, a credit score is calculated using the lender's proprietary analysis techniques, models, and underwriting criteria in general.

The scores for public debt instruments are known as credit ratings or debt ratings (e.g., AAA, BB+, etc.), while those for personal borrowers are usually referred to as risk ratings. The score may be called several different things.

For example, the scores for public debt instruments are called credit ratings or debt ratings (i.e., AAA, BB+, etc.); for personal borrowers, they may be called risk ratings (or something similar).

The score determines the probability that the borrower will default on their loan.

The higher the score/credit rating, the less likely they are to default; conversely, a lower score/rating increases the chances of defaulting.

Mitigation of credit risk

If credit risk is not managed carefully, a lender may experience loan losses. Here are some examples of credit risk mitigation and loan loss prevention techniques used by lenders:

  • Sensitivity analysis - Sensitivity analysis is a method in which a lender modifies some aspects of the proposed credit structure to see the borrower's credit risk if all specified circumstances come to pass.

Let's illustrate. If a lender wants to extend credit at an interest rate of 5%, they may want to check the borrower's credit metrics at 7% or 8% in case rates go up.

Similarly, a lender who plans to offer a borrower a 10-year term loan may want to see what the credit metrics look like for a 6- or 7-year amortization period, just in case conditions change.

Then, the lender needs to accelerate the repayment of the loan.

  • Credit structure - Credit structuring methods can reduce credit risk. The amortization period, the use of (and the quality of) collateral security, LTVs (loan-to-value), and loan covenants are essential elements of the credit structure. If a borrower is deemed riskier, for example, they may be given a shorter loan term than usual and be asked to submit financial statements more frequently.

For example, if borrowers pose a greater risk, they may be required to accept a shorter amortization period than usual.

A debtor may need to submit more frequent (or more detailed) financial statements. This is why it's critical to understand available collateral security and structure credit accordingly.

  • Portfolio-level controls - Financial institutions and non-bank lenders may use portfolio-level controls to manage credit risk. They monitor and determine what particular types of credit make up what percentage of the total loan book and what percentage of total borrowers have a specific risk score.

For instance, if the property market is slowing down, the risk management team at a bank may decide to limit how many mortgages with high-risk profiles they approve relative to the total amount of credit the bank has outstanding.

This way, they can protect the bank against any headwinds the property market might face in the next 12 to 18 months.

In the same way, if the risk management team predicts that a recession might happen soon, it may limit loans to specific higher-risk borrowers.

Understanding the 5 Cs

A framework called 'The 5 Cs of Credit' is widely-used in comprehending credit risk and credit analysis. They refer to character, capital, capacity, conditions, and collateral.

  • Character - If the loan applicant is a personal borrower, the lender will want to evaluate the kind of person they are and what their credit history looks like. For commercial borrowers, lenders will want to assess the management's credibility and reputation. Character evaluations also extend to business ownership (if it's a private operation).
  • Capital - Capital is often characterized as a borrower's "wealth" or overall financial strength. It's also crucial for lenders to determine whether a borrower may be able to get alternate financing from other sources. Is there a family member (usually a parent) who can provide a guarantee for personal borrowers who don't have much credit history? For commercial borrowers, is there a sister company with better liquidity?
  • Capacity - A borrower's capacity is their ability to handle and make debt payments. To measure a retail or commercial borrower's capacity, lenders look at different ratios, including a debt service coverage ratio. Commercial lenders need to develop a good understanding of the borrower's competitive advantage. After all, the ability to maintain or expand this advantage will impact the borrower's future cash flow and loan repayment capability.
  • Conditions – This term refers to the purpose of credit, irrelevant circumstances, or any other external force that might present risks or opportunities for a borrower. Examples of conditions include macroeconomic factors and the current political climate. For commercial borrowers, conditions include social or technological developments that present industry-specific challenges and affect the company's competitive advantage.
  • Collateral security is an essential component of structuring loans to reduce credit risk. It's critical for lenders to know what the borrower's assets are worth, where they're located, and whether the title may be transferred quickly and easily, among other things.

Now that you know how CRE lenders assess and mitigate credit risk, you're in a better position to highlight the things they want to see on your loan application—from the stability of your company's income to the soundness of your CRE project.

A CRE loan application usually requires a long list of documentation about your business and yourself.

The list of documentary requirements for acquiring commercial real estate is even longer, as the lender will want to know all the details about the property—from its price, location, and size to its intended use.

The paperwork required also varies depending on the purpose of the loan, whether your firm is a startup or is already established, and whether you're applying for a loan from a traditional bank or an alternative source of funding, such as a hard money lender.

To make the CRE loan application process more manageable, you may want to work with a commercial property loan specialist that can put your project in front of non-bank investors with less stringent requirements.

Capital Investors Direct is a CRE advisory firm that can customize commercial loan solutions for you.