Margins for Error

I was training a new hire one day, and it immediately became apparent to me how sharp he was and how lucky my company was to hire him. He was underwriting a loan for a contractor who was buying a building, after having rented a different building for several years.

The analyst was quick to understand that rent would no longer be an expense to this contractor, so it made sense to add the rent expense back to income since that would now be money available to pay debt. He then got to thinking about other factors too. He could see the contractor was moving to a space 25% bigger, so he figured the utilities would cost more, and there would be even more real estate taxes that would need to be paid. Then he realized the building was in a different part of the city that would have different utility rates, since they were provided by a different company. His head began to spin! How could he possibly come to understand all the changes about to happen in the borrower’s expenses?

We want to see borrowers succeed, and we also want to incorporate all available data into making a decision. Alas, it is impossible to account for every penny, and our own analysis reaches a diminishing rate of return the more we dig into the numbers. Does it make sense for a salaried person to spend hours of their time trying to account for an immaterial amount of money? Sometimes we need to pull back and assume, all things equal, our borrowers are competent enough to manage the fine details of how they spend their money. Often, we will be happy and sane not knowing how much it costs our borrower to take out the garbage or to buy cleaning supplies.

Underwriting isn’t about turning over every rock to make sure every dollar is accounted for, but rather making sure your borrower can handle unforeseen events. I feel far more comfortable knowing someone can handle unexpected expenses, than knowing every exact expense they realized.

How we assess whether someone is prepared to handle unforeseen events is by making sure there is a “cushion” to protect them. For example, it is not enough to have cash profits to pay your loan, but rather, we would like to see enough profits to pay your loan by a factor of 125% or greater. Or consider someone’s liquidity, we like to see they have enough short term assets to cover short term liabilities by a factor of 125% or more. Even with real estate, we like to see loan-to-value no greater than 75%, so there is some room for the property to change in value, or equity to pay for costs to sale, or even equity that can be financed out to pay for other bills.

A borrower that operates with good, consistent cushions is usually a borrower that knows what they are doing. In doing our assessment to make sure the cushions are in place, we relieve ourselves of having to be a secondary bookkeeper for the borrower, and graduate into asking higher order questions. Questions, such as, is this an acceptable lending risk, and can the borrower still pay the loan if something unusual arises? Probably the type of questions we should be concerning ourselves with!