The Importance of Repayment Sources
Clearly identifying the repayment source of a commercial loan in a credit presentation or write-up may seem elementary to a loan officer or credit analyst; as a result, it is often quickly passed over in favor of what may be perceived as more important areas. However, it is a critical element in an effective risk management process for a financial institution, as it identifies how the loan is intended to be repaid and creates focus for the analysis when underwriting the loan. The purpose of the underwriting is to analyze the borrower’s ability to repay the loan, and the repayment source is the cornerstone for the work ahead. Of course, experience tells us it’s important to identify secondary and tertiary sources as well, in the event things don’t go according to plan.
The primary repayment source is how the financial institution and borrower expects the loan to be repaid. Underwriting should include risks which may impact the primary source of repayment and should further stress test for various factors based upon the borrower’s industry or other potential impacts. When identifying the primary repayment source, try to be as detailed as possible and refrain from generalities. Here are a few examples of understanding and underwriting the primary source of repayment:
- Operating companies: Operating companies generally repay debt through their ongoing business operations, but it’s not always that simple. The primary source of repayment may be different depending on the type of loan provided. The primary source of repayment for an equipment or real estate loan is excess cash flow from business operations whereas the primary source of repayment for an operating line of credit is the conversion of goods or services to cash. With that in mind, begin the underwriting process with these questions in mind: What service or product does the company provide? Who are the borrower’s customers? What industry is the customer in? What is the historical performance of the borrower and its ability to service the debt? What factors could impact the borrower in the future, such as new competitors, loss of a customer and/or changes in the industry? These answers should provide a clearer picture of the risk that the primary source of repayment may not be sufficient. They also help structure the repayment both in terms of loan types, amortization and size of credit facilities.
- Investment real estate entities: Real estate entities generally repay debt through rental income generated from a property held for investment purposes. Development entities generally repay debt through the sale of property or assets. Considering these unique repayment sources, questions should include: What does the tenant mix look like of the property? Is there a concentration of tenants, either in terms of rental income or tenant business type? How stable has the property been? How do the tenants generate revenue and profitability in their own business, and what is the outlook for their respective industries? Are the tenants well established or relatively new? Are tenants national, regional or local? For development or spec loans, it’s important to understand factors impacting supply and demand and the direction of prices. Are other similar properties or developments coming on line which could impact supply and demand and therefore prices?
- Agricultural entities: Farming entities generally repay debt through ongoing agricultural operations, which is primarily the conversion of product to cash. Questions should include: What type of operation is it and how does it generate revenue? How are factors such as crop prices or dairy prices impacting the borrower’s revenues or margins? Is the operation more susceptible to changing prices or less susceptible? How does the borrower protect itself from changing prices?
- Unique repayment sources: Financial institutions regularly provide construction or bridge financing for borrowers, and often the actual repayment source is not properly identified in the credit presentation. For these loan types, we generally see rental income or sale of property stated as the primary source of repayment whereas the actual primary repayment source is the end financing for the construction loan, whether that be at the financial institution which funded the construction or a different lender such as the SBA. In these cases, rental income might actually be the secondary repayment source with the primary repayment source being the take out of the construction loan. Underwriting these types of loans should have a clear understanding of the take-out financing (permanent financing) and factors which may impact it.
The secondary source of repayment is considered the backup plan. Although the analysis does not need to be as in depth on this repayment source, understanding the general ability of the backup source to repay the debt is important. This is often the liquidation of the underlying asset held as collateral, which is why an accurate collateral analysis is important.
Finally, the tertiary source of repayment is the nuclear option – if all else fails, this is your last hope. At this point, the primary source of repayment was not sufficient and there’s a balance left over after liquidation of the collateral. The tertiary source identifies how the remaining balance will be repaid and often involves guarantor support. This is where an understanding of the guarantor is critical. A global cash flow or clear understanding of contingent liabilities will be of assistance and provide value to the analysis. If the credit decision places heavy reliance on the guarantor to fund the loan or support a certain risk rating justification, do not hesitate to independently confirm balances reported on the personal financial statement – the old “trust, but verify” routine.
Identifying the repayment source may not feel like an important component in the overall underwriting process, but a clearly identified and well-established primary, secondary and tertiary repayment source sets the foundation for the analysis and helps to more fully understand the risk in a commercial loan relationship.
Peter Nugent is Director and founder of Enlighten Financial, a specialized consulting firm that focuses on providing loan review and risk management services to community banks and credit unions. Peter guides the company’s service offerings, which include in-depth loan reviews, commercial and personal underwriting/analysis, internal process improvement and workout services. To talk to Peter directly, please call: (920) 354-6797.