This document provides an overview of key concepts for analyzing commercial real estate loans as a credit analyst. It discusses the importance of cash flow analysis through calculating the debt service coverage ratio and net operating income. It also covers loan-to-value ratios, common loan and lease structures, the role of reserves, and factors to consider in evaluating risks to the property's cash flow. The goal is to equip new analysts with foundational knowledge to properly underwrite loans and assess risks.

1. A Credit Analyst’s Introduction to Lending
Written by Christopher Hansson,
First Vice President –Credit Manager at Heritage Oaks Bank
Introduction:
On my first day as a junior credit analyst the first thing I was told to do was to read the entire
loanpolicyof the bank. My managerat the time,whom will remain nameless, had it printed and ready
for me, all 267 pages of it. I remember sitting there in my cubicle staring at this thick stack of papers
askingmyself howinthe worldamI goingto readthisand understandit when I have never worked at a
bank before. To make things even worse, he who shall be nameless thought it was a fantastic idea to
leave on vacation for 2 weeks the day after I started, leaving me to fend for myself in this seemingly
unforgiving world of commercial banking.
There are a few problemswiththisapproach;the loanpolicymightaswell have beenin Klingon
as it is riddled with acronyms and nomenclature that only bankers understand (we have all heard of
“bank-speak”),the loanpolicymightbe the most boring thing you will ever read in your entire life and
will make you wish you had never gotten out of bed that morning, and the lack of mentorship almost
killed my aspirations to continue my career in commercial banking before it had even begun.
The purpose of this paper isto be everythingthatIdidn’tget;funny,insightful,andeducational.
The most important thing for anyone that is new in the world of commercial banking is to have a
support structure available to foster critical thinking, decision making, and growth.
If you have foundyourself lucky enough to land a job as a commercial credit analyst at a strong
and reputable bank with a manager that truly wants you to succeed, your job is underwriting, which I
understand probably means very little to you at this point. Underwriting is pretty straight forward as
long as you are perceptive, have good writing skills, understand basic arithmetic (meaning you know
how to use a calculator and Microsoft Excel), and have a fundamental understanding of GAAP
accounting.
Essentially,yourjobisto evaluate if aloanisgood or bad andif it fitsthe banks risk parameters,
all of which are easiersaid thandone.Now thisisnot the only thing you may end up doing; you have to
do some very mundane and mind numbingly annoying tasks such as pulling reports, collecting
information,scanningstuff, makingfolders,etc.Inanycase,underwritingisthe mostinterestingandfun
part of your job, and if you do it right you have a long and diverse career ahead of you.
At most commercial banking institutions there are two main types of lending products;
Commercial Real Estate (CRE) and Commercial & Industrial (C&I) loans (mergers & acquisitions,
equipmentfinancing,workingcapital,etc.) However, mostbanksin my area are heavily focused on CRE
and those typesof loansare much easiertoexplainthanC&Iloans.Assuch,thisarticle will focus on the
underwriting of CRE loans, which as a junior analyst you will be exposed to the most as they tend to
require similar types of analysis.
There are two fundamental metrics that are of utmost importance to underwriting a CRE deal;
the cash flow and the Loan-To-Value (LTV). Both of these metrics rely upon each other and should be
rigorouslyanalyzedbothseparatelyandtogether before making a recommendation on a loan request.
We will start by discussing cash flow then transition to the LTV.

2. Cash Flow
Cash flow is king! I will defend that stance until the day I die. Many bankers are completely
reluctant to do any loan unless its collateral is cemented to the ground and has a roof, which is a big
reasonwhy C&I loansare sodifficulttodo;theygenerallylackreal estate collateral.Sowhatiscashflow
and howdo youas an analystactuallyfigure outif it is good or bad? The most fundamental approach is
pretty simple and is called the Debt Service Coverage Ratio (DSCR). As the name implies, it measures
how many times yourcash flowcoversthe requiredpaymentsonthe loan,prettysimplehuh?The more
complicated task is how to properly calculate cash flow, which I will now attempt to explain.
Common Term Structure:
The most common structure for CRE loans is with a 10 year maturity and the payments are
based upon a 25 year amortization. What this means is that the loan will come due in 10 years but the
monthly payments are calculated based upon 25 years. With this structure the borrower will have
something called a “balloon payment”, meaning that at the end of the 10th
year whatever principal is
left on the loan comes due immediately unless the loan is refinanced with your bank, another
institution, or is fully repaid by the borrower (99.9% of the time the borrower will refinance).
Thisstructure is primarily done so that the borrower will have lower monthly payments, but it
alsoallowsthe bankto adjusttheirratesat maturityto reduce theirinterestrate risk, meaning they can
price the loan higher at that time to coincide with the prevailing market rates should they have
increased.Butwhatif rateshave decreasedyoumayask? Well inthe vast majority of cases bankers put
an interest rate floor on the loans, meaning the rate cannot dip below that floor at any point in time
during the loan term. In addition to this, many bankers will quote the borrower a rate reset structure,
meaningthatthe rate will be fixedforanumberof yearsand thenresettoa differentrate forthe restof
the term. This effectively reduces the banks downside risk of interest rates, and the reset structure
allows the bank to capitalize on any upward movements in market rates.
Debt Service Coverage Ratio (DSCR):
The DSCR is calculated by dividing the net operating income (NOI) of the property by the total
annual requiredprincipalandinterestpaymentsonthe loan(commonlyreferredtoas debtservice).For
example, let’s say you calculate a property’s annual NOI to be $100,000 and the annual required debt
service is $75,000 you will have a DSCR of 1.33:1.00 ($100,000 / $75,000). The annual debt service is
pretty easy to figure out by using a financial calculator, excel, or an amortization schedule.
From a bank’sstandpoint, the higher the DSCR the less risky the loan is since the property will
generate more in excess cash flow after all expenses and debt service. This means that the property
couldsustainincreasedvacancyor increased expenses and still have enough NOI to service all of their
debt payments. My starting point for any loan is that the DSCR need to be at least a 1.25:1.00 after
distributions, but this will vary from bank to bank. Wait, distributions, what is that? Well, if you own a
commercial property,oranyotherinvestmentforthatmatter,youexpectto make some moolahfrom it
right? (If you want to learn how NOT to make money on your investments I can give you my brother
phone number and he will walk you through it).
Distributionsare the most common way property owners monetize their return on real estate
investments and represents cash paid to the owners. But wait won’t these distributions reduce the

3. amountof cash available topaythe banksdebtservice, which in turn would increase the risk profile of
the loan? Let’s go back to our first example with $100,000 in NOI and $75,000 in annual debt service to
answerthat question.Let’snowalsoassume thatthe ownerspaidthemselves$40,000 in distributionsin
that year. To incorporate this outflow of cash to the owners the DSCR formula is now (NOI –
distributions) / annual debt service, or in the case of our example ($100,000 - $40,000) / $75,000 =
0.80:1.00. I am goingto pause here fora secondandletyoulookat that ratio.If youdon’tsee a problem
here I suggestyoure-readthisarticle multiple times. If you still don’t see a problem then I suggest you
go back to school.
Since you continued reading I am assuming your understand that a DSCR below 1.0:1.0 means
that the property will not have enough cash flow to support the bank’s debt payments, which in turn
signals to the bank that the risk of payment default increases significantly. It is imperative that the
lendingofficershave candidconversationswith their borrowers about distributions and what the bank
will require of them in terms of DSCR covenants (covenant is another word for requirement). For
practicallyall CRE loansthere isa minimumannual DSCRcovenant,anditshouldalwaysbe calculatedas
NOI before and after distributions.
Net Operating Income (NOI):
But, at thispointyouare probablyaskingyourselfwhatisNOIandwhere doI findit? Essentially
NOI is the net profit of the property after adding back certain expenses such as depreciation &
amortization, andinterestexpense. Or another way to put it is gross rental revenue + reimbursements
(explained shortly) – vacancy – total expenses + depreciation & amortization + interest expense. You
may askyourself whywe are addingback these expenses.Wellasyoushouldhave learnedinaccounting
class, depreciation and amortization are non-cash expenses and is required by GAAP and the IRS to
allocate the costof tangible orintangible assets over its useful life, but it does not require you to cut a
checkfor that amount,meaningnocash hasbeenusedtorecognize that expense. As my first sentence
of this section stated, cash flow is king, and if you have non-cash expenses within your income
statement and we want to know what the actual cash flow is, it stands to reason that those expenses
should be added back to net income in order to arrive at actual cash flow.
Now, interest expense is added back as well, but why? Well we are trying to determine NOI,
which is the cash flow available to service the principal and interest payments BEFORE the payments
have beenmade.Adding back interest expense then allows you to arrive at the NOI available for debt
service. Butwhatabout principal? The principal portion of your borrower’s monthly payment is not an
expense; rather it is a reduction of a liability, a balance sheet account. As such, you should never see
principal as an expense on the income statement.
Up to thispointI have beenverygeneral inmyexplanationof cashflow,butas youwill soonsee
it can be quite complicatedonce yougettothe nuts and bolts of it. All investment properties generate
income through the collection of rents from the tenants. On the flip side, in order to generate this
income one alsohave to incurcertain expenses; insurance, repairs & maintenance, management fees,
real-estate taxes, etc. All of this information is generally found on the tax returns and operating
statements of the property. In addition to regular rental income, many leases require the tenants to
reimburse the landlord(yourborrower) some of the expenseshe/she incursonamonthlyand/orannual
basis.Thisisa greattime to introduce ourconversationon leases! You will learn to love and hate them
during your tenure as a credit analyst.

4. Leases:
What isincludedinanylease iscompletelyup to what the landlord and tenant can agree upon.
This in turn means that there are an infinite number of lease structures out there, but for purposes of
simplicityIwill discusssome of the easierstructures. The simplest lease is that the landlord will pay for
all expensesof the propertyregardless what they are. Now, this obviously opens up the landlord, and
your borrower,tosome seriousriskinthe event expenses increase significantly. These types of leases
are notthat commonbecause the majorityof propertyownersare smart enough to realize this risk and
will require reimbursement of at least some of the expenses. If you encounter a lease like this, you
better call it out to the lender as a risk and find mitigating factors to the repayment risk it creates, if
there are any.
In the vast majorityof casesthe landlordwill passonsome orall of the expensestothe tenants.
For a single tenantbuilding,decidingwhopaysforwhatexpense iseasyasthere is only one tenant, but
when you have multiple tenants it can become more complicated. Sometimes the lease allocates the
responsibilityasa fixedpercentage,fixedbase amount,orall expenses. AsIsaid,anything they agree to
ispossible aslongas it is within the confines of legality. If a tenant agrees to pay all the expenses, it is
called a triple net lease, or NNN for short. It should be pretty obvious but with a NNN lease the actual
rent the tenants are charged is more than likely going to be much lower compared to non NNN leases
since the tenants pay for all other expenses incurred by the landlord.
There is anothercategoryof expensesthatare usuallynotpassedonto the tenantsinany lease;
the reserves. Reservesare expensesthatdonotoccur regularly. Forexample, large capital costs such as
replacingthe roof or othermaterial expensesincurredtorepairthe structure of the building.Now if you
are a savvy ownerof a propertyyoushouldknow toputaside a portionof your profitstoreserve against
these inevitablefuture expenses,butinrealityyouwill find that many real estate owners would rather
take the distributionsnow andthenworry about it in the future. This usually means they come back to
the bank asking for more money to finance the requirements.
However,if youasa commercial bankerimplementedaminimumDSCRcovenantof say 1.25:1.0
when you made your loan, you have effectively required the borrower to at least reserve 25% of one
year’sprofits orelse theywouldbe indefaultonthe loan.Now thismaynotbe enough,especiallyif you
made the mistake toleverupa propertythat looksmore like adilapidatedshack. So what can you do to
ensure thatyour borrowerhasenoughreservesinplace forwhentheyneedit?Yousimply require them
to retaina specificamountinreservesforthe life of the loaneitherupfrontor allow them to build it up
overa certainamount of time. This will help the borrower and the bank feel more comfortable that in
the future there will not be as large of a financing need and the property’s cash flow will not be
adversely affected.
Reserves:
Reserves come in two main categories: tenant improvements and structural repairs. Tenant
improvements (TI’s) are costs incurred to remodel or upgrade the interior of the space and is usually
paidby the landlord(there are some leasesthatrequirethe tenantstopayfor anyTI’s theywantthough
so keepaneye outfor that).In orderto entice new tenantstoa vacant building/space the landlord may
put innewpartitioningwalls,carpeting,windows,anddiamondencrustedlampswitches. Now,manyof
these TI’swill actuallyincreasethe value of the space and provides benefit to the landlord as well, but
for itemssuch as diamond encrusted lamp switches that will have to be paid for by the tenants (if you
come across a landlordthatiswillingtopayforitemslike thispleasesnapaphotoof the lease and send
it to me and thenimmediatelyquestion the persons mental health). Structural reserves are for repairs

5. that are considered extraordinary in nature such as replacing the roof or completely replacing every
electrical wire of the building.
Banksmay also require borrowerstohave reservesforsomethingcalledroll-overrisk.These are
situationswhenmaterialleasesexpirepriortothe maturityof your loan. Whyis this a problem you may
ask? Let’s say you are asked to provide a 10 year loan for a building that has two tenants, one that
contributes 80% of the rental income and one the remaining 20%. The 20% tenant has a 20 year lease
and the 80% tenant has a 5 year lease. I bet you see the problem by now but I will continue
nevertheless. In 5 years, halfway through your loan term, the large tenant has the option to pack up
their stuff and leave, which ultimately leaves you as the banker with an 80% vacant building with NOI
insufficient to make your loan payments, obviously a huge problem.
If this is a serious concern for the property then it would be wise for the bank to require the
borrower to place reserves in a bank controlled account for 6-12 months’ worth of loan payments so
that the borrower can find a new tenant for the vacant space without the bank risking any payment
default during this time. If ultimately the borrower cannot lease the space then you have a bigger
problemonyourhand and isoutside of the scope of thisarticle,butsuffice ittosay that reservescan be
a very powerful tool for you as a banker.
Recap:
So let’s recap here. NOI is calculated by (gross rental revenue + reimbursements – vacancy –
total expenses+depreciation&amortization+interestexpense). The variables within the NOI formula
require the analysisof leases,expense structures,loanterms,owner distributions, etc. In addition, you
as the analystare expectedtocall outany risksassociatedwiththe property,itstenants,the leases, the
condition of the building, and ultimately the cash flow capacity of the property.
The LTV
So nowthat we have gone overcash flow,itistime to focusour attention on our collateral. The
main metric used to determine not only the size of the loan, but also the risk of the loan, is the
estimatedmarketvalue of the property.Aswith cash flow the formula to determine this is simple, but
requires quite a bit of analysis to properly evaluate.
The LTV is calculated by dividing the amount of the loan by the amount of the value of the
collateral, e.g. if the collateral is worth $1,000,000, and the loan is for $650,000 the LTV is 65%. From a
banks perspective, the lower the LTV is the less risky the loan. Every single bank on the planet have
policies in place that dictate what the maximum allowed LTV is for certain CRE transactions but a
general guideline isthatthe LTV shouldbe lowerthan75%. Dependingonhow your bank views LTV’s, if
the percentage islowenough it may be considered a strength, and it may also open up an opportunity
for the lenderto relax some other structural requirements and even reduce the interest rate charged.
As I said, to compute the LTV requires two ingredients. It is simplicity itself to determine the
loanamount.(Well,of course there actuallyissome complexityhere.Foranew loan,you have to figure
out exactly what the borrower is asking for and what you might offer. Often, the loan amount will be
determined by working backwards from what LTV you are willing to have for the loan, and the bank's
determinationof the value of the collateral.) The more interesting question is; how do you determine
the value of the collateral?

6. Appraisals:
So, what iscollateral?Collateral iswhateverof value the borrowerpromises to give to the bank
if he is unable to repay the loan. In the case of a real estate lender, collateral for the loan is usually a
piece of commercial real estate property.One easywayto find out the value of a piece of real estate is
to get an appraisal. Most banks get an appraisal for every real estate loan it makes above a certain
amount and failure to do so is an exception to the bank loan policy, and in some cases it is also a
violationof federalbankingregulations.The appraisal isprepared by a certified appraiser on the bank's
approvedappraiserlist.All appraisalsmustcontaincertain elements and conform to certain regulatory
standards.
An appraisal shouldexplain the methodologies employed by the appraiser in determining the
marketvalue of the property.Appraisalsshouldalmostalwayscontainthe following three "approaches
to determiningvalue": (1) the income capitalization approach, (2) the replacement cost approach, and
(3) the market comparison approach. I describe the approaches in reverse order.
Market Comparison Approach:
In determiningaproperty'svalue bythe marketcomparisonapproachthe appraiserattemptsto
find comparable properties ("comps") that have been recently sold and thereby estimate what the
subjectproperty could be sold for. To determine the value of the subject from the study of comps the
appraisermustreconcile forwhatevervariablesmightmake the value of the subject different from the
comps. These variables include: size, location, age, condition, design, and anything else the appraiser
can think of.
Replacement Cost Approach:
The replacement cost approach asks what it would cost to actually build the property from
scratch. This approach presents a number of difficulties. What is the price of vacant land on which to
build? This is especially difficult to answer if there is no comparable vacant land in the area. Another
problem is that a building's value might be decreased substantially by wear and tear, which we call
depreciation. (That's not quite accurate. Depreciation also includes a loss of value that is caused by
functional obsolescence evenif whateverisdepreciating isperfectlymaintained.) Of course, there is no
way to build a new building that is worn and torn. Despite these problems, for a newly constructed
building in the middle of the cornfields, this method makes a lot of sense. Why would anyone buy a
building for more than he would have to pay to buy vacant land across the street and have it built for
him?
Income Capitalization Approach:
The third methodisthe mostcomplicated,andpossiblythe most meaningful. It is certainly the
method the bank pays the most attention to. Why? Because the income capitalization approach is
concernedwiththe essence of financial investment:the return.People investinreal estate forthe same
reason they invest in stocks, bonds, futures, or lottery tickets: to make money. The final test of your
investment,inhindsight,is what return you made from it. For our running example in this article, let’s
say a 10% return is realistic. What this means is that someone who buys a building for $1,000,000
expectstoearn$100,000 per yearin income fromthe building.Anappraiser(andthe bank) attempts to
reverse thiscalculation anddeterminefromthe income produced by a property what it is worth. In our
example, let’ssay the appraiser determined that the income was $100,000 and divide that by 10%, the
return, and calculated that the building was worth $1,000,000.

7. There are a couple of fancytermsthat real estate people use whenreferring to this calculation.
Insteadof talkingaboutthe income,we alwaysspeakof the NOI.Andinsteadof talkingaboutreturn,we
alwaysspeakof the capitalizationrate,orthe cap rate.To determinethe NOIthe appraiserperformsthe
calculationIdescribedinthe sectionaboutthe DSCR.Once he has the NOI, the appraiser computes the
value of the property by dividing the NOI by the cap rate as described in the previous paragraph.
The cap rate can be interpretedasameasure of the property's riskiness. A property that is sure
to produce itsexpected income should have a low cap rate. Conversely, a property that is risky should
have a high cap rate. Why? Consider two properties that are both expected to produce an income of
$100,000 per year. For whatever reason, Property A is considered a lock to produce that income,
whereasPropertyBisa gamble.The marketplace issoconvinced that Property A will produce $100,000
in income every year it could sell for $1,100,000. To justify that value, Property A must have a cap rate
of 9.1%. (Check on your calculator: $100,000/9.1%=$1,100,000.) Property B, on the other hand, has
investorssonervoustheywillonlypay$900,000 for it.Therefore,the cap rate applicable for Property B
is 11.1%.
Real estate people love talking about cap rates. You're not prepared to go into battle until you
feel comfortable answering questions like "What cap rates are downtown industrial buildings trading
at?" What this question means is; what is the price of industrial buildings in relationship to their
income?
Since cap rates are a measure of risk they depend on property type. For example, hotels have
highcap rates,residential apartmentbuildingslow caps and office and industrial buildings somewhere
inbetween.(Considerthe above sentence.Whatdoesitimplyaboutthe relativeriskinessof those types
of properties?) Capratesare alsoa measure of the basicreal estate climate.Ingoodtimes cap rates will
fall acrossthe board.In badtimesthey'll gothroughthe roof.Andwhentimesare reallybad,there is no
such thingas cap rate since propertiesaren'ttradingatall,i.e.noone will buyyourcrummy buildings at
any price.
After doing all three independent appraisal approaches, the appraiser should attempt to
reconcile the three values. In doing so he should explain how much weight was given to each
methodology andwhy.The appraisal should conclude with a date and a single value for the appraisal's
date.
Other thoughts:
Leavingthatexhaustingdiscussionof appraisalsaside foramoment,let's think of an easier way
to determine the market value of a property. An investment obviously has an associated cost: in the
case of real estate investmentitisgenerallythe costof buying or building the property. With this value
you can compute a particular example of the LTV, the loan to cost ratio. The actual cost of an
investmentisof greatimportance tothe bank.If an appraisal says the property is worth $6 million, and
the borrowerispurchasingitfor $3 million,andaskingfora$3 milliondollarloan,thenanunsuspecting
creditanalystmightsaythat the LTV was 50%-excellent!Of course this would be nonsense; the loan to
cost is actually 100%-terrible.
Why shouldthe bank assume all of the risk of the transaction while the borrower reaps all the
future benefits? Normally a bank will lend a maximum of 75% of the appraised value or 75% of the
purchase price, whichever is lower. At this point alarm bells should be ringing: how on earth can the
purchase price be so far from the appraised value? Before you even think about making a loan for this
transaction in any amount, you had better understand fully why there is such a great discrepancy.
Anotherimportantquestionthatshouldbe answeredishow muchof their own actual money is
the borrower putting into the deal? This amount is called the borrower's equity. There are two big
reasons for this. The first is that an equity investment keeps a borrower on the hook. After plunking

8. down a million of his own dollars a borrower is much less likely to simply hand over a building when
timesare rough andwalkaway.The secondisthat a highequityinvestmentisconvincing proof that the
lowLTV we calculatedactuallyhasa basisinreality.Andthe lowerthe LTV, the less likely the bank is to
lose money, even if the borrower does give up and walk away.
Borrowers and Guarantors
Afterall of that you are still not done! The bank still needs to evaluate the relative strength of
the customer, which can be an individual, corporation, LLC, or any other form of entity that can hold
property as an asset. For now, I use the terms more or less interchangeably, and by them I mean to
indicate the person doing the borrowing, the customer.
As we have alreadydiscussed, propertyhastwocharacteristics that it is critical for an analyst to
understand:itsvalue anditsincome (LTV andDSCR).The same applies to the customer, but we refer to
a person's value as his net worth. The basis for computing a customer's net worth is his personal
financial statement (PFS). This is essentially a balance sheet which lists all the person's assets and
liabilities.
Personal Financial Statement and Net Worth:
Surprisingly, many people exaggerate their net worth. A house purchased for $150,000 a year
ago is now worth a whopping $250,000. That real estate portfolio of two decrepit flats built in 1926 is
worth a cool $1,000,000. Their25% interestin the family plumbing business: $600,000. The 1992 Chevy
Impala:$40,000. For thisreason,a creditanalysthasto go through the listof assetsand make a seriesof
adjustmentstothe customer'sfinancial statement to arrive at a more realistic figure of the customer's
net worth.
There are at least two types of assets which are easy to value: cash and marketable securities
(stocks & bonds). The only question about them is whether you believe they actually exist as the
borrowerdescribes.(Onequicktestistocompare the customer'stax return with his PFS. If he claims to
have a stock portfolio of $1,000,000 and shows dividend income of $436 on the tax return, alarm bells
should ring). In many cases, banks will require borrowers to provide liquidity verifications, which is a
fancy way of saying, show me the money!
Real estate assetscan be verifiedbythe bankbya varietyof methods.Asking for appraisals, tax
returnsfor the entitiesthatownthe properties,inspectionof the propertieslisted, pullinga preliminary
report to verify how the property is vested, and online resources such as Zillow.com.
Ownership interests in privately held companies are extremely difficult to value. Certainly a
businessthatprovides the customerwitha stable $150,000 income per year must be worth something.
However, the value of the company is contained in the people running it. If the customer and his
partners/family quit, the business could very quickly be worth nothing, or less if there are remaining
debts. For purposes of calculating net worth my stance has always been to 100% discount any closely
held businesses.
Residential propertyiscertainlyworthsomething,butif there isalreadyan80% home mortgage
on the property,itisunlikelythatthe customerwill be able to raise much money to pay his debts from
this source. Personal property like cars, TV’s, stamp collections, and antique Chinese dolls should be
discountedata conservative rate of,say,100%. Not onlyisa borrowerunlikely to be able to raise much
moneysellingthe 1992 ChevyImpala,he'sunlikelytowantto.More likely,you'll foreclose longbefore a
borrower starts selling personal property.

9. Most banks use something called Outside Net Worth (ONW), which discounts all intangible
assetsand/orassetsthat are unlikelytohave much value. There is much more to this calculation and is
outside the scope of this writing.
Personal Cash Flow:
Afterdetermininga realistic figure for the person's net worth a credit analyst's attention turns
to the customer's income. You can determine someone's income by reading it off his tax return, but
banks use spreading software where you input all of the salient parts of the tax return into. The
software then spits out a standardized format for cash flow and other neat metrics.
It wouldbe nice tohave two or three or even four years of tax returns to make certain that the
income level is consistent, or even better, rising. Watch out for extraordinary items, such as sales of
propertyor inheritances,whichcaninflate income forone year.Ideallyareal estate owner should have
a steady stream of income from his developments and holdings. Be advised that simply reading the
income fromthe tax returncan give youa false sense of the real cash the person earned in a year. Real
estate can involve considerablenon-cashexpense suchasdepreciation.Togeta true sense of the actual
cash income the analysis should include adjustments, or "add-backs", of the non-cash items.
Conclusions for Personal Financial Strength and Support:
Aftergettingasense of whatthe customeris worth, and what the customer makes, the analyst
is still left with a big question: how does the customer's income and net worth contribute to the
soundnessof the loan. A personwitha networth of $1,000,000, includingliquid assets of $500,000, and
a real property with a recent appraised value of another $500,000, is a great guarantor for a $350,000
loan,and a lousyone fora $15,000,000 loan.Ideally,all borrowerswouldhave liquidresources to repay
their loans immediately; hence the old crack about bankers only lending money to people who don't
need it.
Of course such strong customers are rare. As a rule of thumb you would like the borrower to
have sufficientresourcestobe able tocarry the propertyforsome period of time. Problem loans are in
my experience often traceable to a tight but sufficient DSCR, an acceptable but aggressive LTV, and a
weak borrower. Any property is going to have problems that will require infusions of capital. In time
these repairs should pay for themselves, but that doesn't help a borrower who needs $25,000, or
perhaps $2,000,000, today. If a borrower is stretched thin: his only liquid capital is a checking account,
or he's taking a second mortgage on his residence to make the equity contribution to the transaction
you're underwriting, or his entire portfolio is highly leveraged, it's a time to worry.
Determining how much extra security a particular guarantor brings to a loan is a very difficult
question.Notonlybecause it'ssomuchharderto determine whatapersonisworththan a building,but
because italsorequires a measurement of the person's character. Making that judgement lies beyond
the scope of this discussion.

10. Presentations and Reviews
There are two different kinds of reports that lenders/analysts are called upon to write about
loans:creditpresentationsand reviews. A presentation is for a proposed loan, and a review is a yearly
report written for a loan that is already in place.
Credit Presentations:
Presentationsare writtenby analystsandloanofficers to convince the appropriate authority to
allow the loan to be made. As such, a presentation is something of a sales brochure. The loan policy
manual explicitly denies this is true, but I choose to disagree. A loan presentation should of course
alwayscontaina thoroughdiscussionof any negative factors that may make a loan unsound. An officer
or analyst who does not fully disclose known weaknesses of a loan that could jeopardize the banks’
capital and profits tohisbosses is one who deserves to be fired. But, no officer would ever go through
the time and trouble of negotiating and vetting a deal that the he did not want to see closed.
The very first page of a presentation should always contain exactly who the borrower for the
loanis,exactlyhowmuchmoneythe borrowerwants, on what terms the money will be lent, and what
the purpose of the loan is.Once these basicsare laidout,a presentationshouldalsocontainanin depth
discussion of each of the topics I discussed above. In addition, a presentation should cover the bank's
previoushistorywiththe customer. A presentation should also contain a discussion of other loans the
customer has at the moment. We refer to this as the bank's exposure to the customer.
Presentations are generally not long. If a presentation is more than a 12-16 pages, either the
deal is exceptionally complicated or the discussion is exceptionally longwinded. Sadly, many
presentationssufferfromthe latterdefect.However,presentations almost always contain a number of
exhibits.Exhibitscansometimesquadruple the thicknessof apresentation,evenif the person preparing
the exhibits is not particularly longwinded. (Beware of presentations and officers that fall into the
underwriter's fallacy. No matter how thoroughly and well underwritten a property is, it does not
increase the value of that property one cent. It seems obvious, but if you keep your ears pricked up,
you'll be surprised how often you hear people fall into this trap.)
Sometimesanofficerwill writealoanpreview before writing a full-blown presentation. A loan
previewisshorterandlessdetailedthanapresentation.Itgivesthe higherauthoritiesanopportunityto
give theirinputintodealsbeforenegotiationsgo toofar,and to kill dealsthatthe bank is not interested
in before officers waste too much time on them.
Annual Loan Review:
The other type of reportabout loansisthe review.A review looksalotlike apresentation, butis
in general shorter and does not change the structure of the deal (generally). A number of different
attitudesexistaboutreviews.Sadly,manyof these attitudesare irrational. On one end of the spectrum
are the people whoare constantlyreinventingthe wheel (andthe screw,the pulley,the lever, and fire).
These people want to see every detail about the loan that can possibly be mustered. Since there is
generallymore informationaboutaloan a year into it than when it was originally made, these reviews
can get ridiculouslylong.Some people putineverythingbutthe kitchensink,andIhave the feeling that

11. if they had a powerful enough stapler they would stick that on too. To these people I say, remember,
this is a review. The loan has already been made.
Certainlythe bankisinterestedtoknow if the propertyis performing as expected but, whether
it is or not, there is little that can be done about it now. We already got into bed with the borrower
when we made the loan, and no amount of reviewing is going to get us out. The other end of the
spectrumislessannoying,inasmuchasitcreateslessworkforanalysts,butstill createsproblems.These
are the people whosee no purpose in doing reviews. They allow loans to remain unexamined, or only
cursorilyexamined,foryearsata time.To these people I say, wake up. Doing reviews might not be the
mostexcitingpartof your job,but itis part of your job,andour regulatorsexpectustocomplete annual
reviews on our real estate portfolio (these are people we do not want to disappoint, believe me.)
If a loanhas deteriorated,the bankshouldknow about it,andtake appropriate precautions. If a
customerisdoingparticularlywell then the bank should be pursuing that customer for more business.
Andif a loanisdoingsimplyasexpected,thenareview of itshouldbe aquickand painless process. At a
minimumareviewshouldcontainthe following:acommentonthe paymenthistoryof the loan, analysis
of performance (cashflow),anestimationof currentcollateral value, a check of the tax escrow, a check
for up-to-date property insurance and other important documents, and an inspection of the property.
Reviews are generally the first exposure to underwriting that credit analysts get. Many credit
analysts become resentful that they work so often on reviews and so rarely on new loans. To these
analysts I say, enjoy it while you can. Reviews are generally graded on a much lower standard than
presentations,andtheycanaffordmore of an opportunityforcreativity,since officerswill be mellower.
Once you are exposed to the hyper-criticism that can accompany your CCO or Credit Administrators
reading of your presentations, you may well find yourself pining for those carefree days of boring old
loan reviews.