Thanks to a strong real estate market and rising interest rates, banks are more eager to lend than at any time in recent memory. Business borrowers, though, must lay the groundwork for a successful loan application by improving cash flows and initiating communications with bankers long before money is needed. Smaller banks can help fill the gap when larger ones refuse to extend credit.
Here’s good news if your business needs money for renovation or expansion: Financial institutions are more eager to lend than at any time since the Great Recession.
“As more banks have worked their way back to profitability in recent years, there has been a loosening of the purse strings,” says John McQuaig, managing partner of McQuaig & Welk, the Wenatchee, Wash., based management consulting firm.
The trend is likely to continue, for several reasons. One is the anticipated loosening of federal regulations that have restricted bank lending practices. A more immediate force, though, is the higher cost of money. “Rising interest rates improve banks’ margins, and if they become more profitable they can potentially lend more,” says Linda Keith, an Olympia, Wash.,-based CPA with a niche practice in lender credit training.
Of course, higher rates are a two-edged sword. They also increase the costs of money for business customers, and the higher payments make it harder to qualify for loans. “Most small businesses who obtained variable interest rate loans in 2016 or earlier will see an increase in their monthly payments,” says Denise Beeson, a small business consultant based in Santa Rosa, Calif. “For some borrowers, this increase may not be substantial. However, we anticipate further rate increases in 2017.” Even so, the nations’ historically low interest rate environment means there is still some room for rates to grow without having a huge impact.
An improving commercial real estate market is also driving more business lending in most regions of the country. That’s good news for anyone using property as collateral. “Many banks are now willing to lend up to 80 percent of property value, higher than the 65 to 70 percent in the years following the Great Recession,” says McQuaig.
That happy condition is not universal, however. In some areas the real estate market has overheated, sparking fears of overvaluations. As a result, some banks are reducing the amounts they will loan on appraised value.
“Banks need confidence in the local market and in real estate appraisals to support loans,” says Keith. “They will ask themselves, ‘Do valuations really reflect what a seller can get for the property?’”
Despite the improving lending environment, one thing hasn’t changed since the dark days of 2008: A heightened banking interest in customer cash flow. Indeed, while collateral can be important for the lending machine, it is no longer a driving gear.
“Banks are looking for quality performing loans,” says Keith. “They want to see, first, that the business borrower can repay a loan using cash flow generated from operations. Second, they want to see good liquidity, so if the operations don’t come off as planned the borrower has enough money to pay as agreed.”
As a third line of defense, adds Keith, banks look for a personal guarantee: Does the owner have enough funds to backstop the business? And finally, what’s the current debt load? Does the business have room to borrow more?
It all comes together to produce a loan decision, “With those various potential sources of funds,” says Keith, “the bank hopes it will not have to collect on the collateral.”
Of the four indicators mentioned above, the most critical is the first: debt coverage (the ratio of net cash flow to annual principal and interest payments). Banks expect business borrowers to generate 120 to 130 percent of their total loan payments in net cash flow.
Here’s an example: Suppose your annual payments for principal and interest come to $100,000. Then you need to generate at least $120,000 in cash flow after all other expenses are paid.
And that 120 percent figure is a bare minimum today, says Keith. Banks are more comfortable with 125 percent. For reference, back in the Great Recession they were requiring a 135 percent.
Small is good
“Finding the right bank for your deal is important,” says Brad Farris, principal at Chicago-based Anchor Advisors (anchoradvisors.com). “A big megabank offers complex and large financing, and the decision to lend is all about the numbers. Your local community bank, on the other hand, provides leasing and lines of credit and SBA real estate loans, and the decision to lend often depends on your relationship with a human being.”
That personal touch can be critical. “You want a bank that understands what you are doing and what your plans are,” says McQuaig. “A community bank is more likely to do that. While bigger banks are looking to serve big customers, smaller ones may use other means to qualify business loans beyond a simple analysis of cash flow.” Credit unions, too, says McQuaig, are expanding their commercial activity, but are still not terribly experienced in that area.
Smaller banks are of special importance because of their dependence on small business lending, says Keith. “Their very survival depends on finding quality loans. This is great news for small businesses with good fundamentals.”
But know the downside. “The smaller banks have to be very careful how much they lend, because they have a smaller pool of funds,” says Andrew Clarke, President of Chicago-based small business consultancy Ground Floor Partners (groundfloorpartners.com). “A $100,000 loan default is a much bigger hit on a $20 million portfolio than on a $500 million one. Bigger banks might have tougher terms, but at least they have money to lend.”
When it comes to landing a loan, numbers alone won’t carry the day. “Start talking with bankers to build relationships long before you need money,” advises Clarke. “If bankers know you to be a reliable, serious person you will have a much better chance of getting a loan approval. That’s true even though small bankers do not have much direct authority, since underwriting decisions are often made elsewhere. Even so, they can grease the wheels.”
Successful communication is an ongoing process. “Market to your banker like he’s a business prospect,” says Farris. “You need a plan for feeding your banker news about your company and what is happening, so the banker feels comfortable with what you have borrowed. Manage the perception of what is going on with your business.” (For more ways to cultivate bankers see the sidebar “How to Land a Loan.”)
Communication is a two-way street: Keep yourself tuned to what is happening at your bank—especially about any changes that might disrupt your credit line. Business people often assume their line of credit is safe as long as they maintain their covenants. But that is not always the case. “When a bank wants to pull your loan it can come up with a rationale,” says Clarke. “It can find some financial ratio it doesn’t like.”
Be especially wary of bank mergers. “When a big bank buys a small bank there always seem to be unwanted assets that do not fit well with the portfolio,” says Farris. “So the combined bank often refuses to renew certain lines of credit, or refinance loans. And that creates a lot of disruption in the customer base.”
Finally, be alert for a common pitfall: The tendency of small business bankers to move from bank to bank. “You build a good relationship so your banker will help you out when the time comes to borrow money,” says Clarke. “But all of a sudden you find your friendly banker has gone to a new employer and has not yet cultivated those internal relationships required to help you get your loan.”