The other day we had a request for a new commercial construction request for an apartment. The total project was around $10,000,000 with the borrower putting up the land, estimated to be worth $1,000,000 and then putting in another $1,500,000. Things looked good until we got down to the net worth of the sponsors.
These gents were highly leveraged and only showed a net worth of $500,000. What? The sponsors want to borrower $7,500,000 and only have a net worth of a paltry $500,000? When you dug down into their balance sheet, most of the equity was tied in an estimated equity of real estate. Cash and investments were reported at less than $20,000. Given these items, what financial strength does the sponsor have to support the deal?
An old rule that I learned when looking at construction projects is the sponsors on the project need to have a net worth at least as large as the construction loan they are requesting. This would especially apply in the case of a spec construction, but some other types such as an SBA guaranteed project would not necessarily apply. In this case the $7.5MM loan would be matched with sponsors with at least $7.5MM of net worth, and not inflated equity net worth, but financials that are realistic.
Now in times when lending is tight, some lenders want to see this ratio at 1.5 times or more. In times when lending rules are easier, lenders rarely will go below a net worth to loan ratio of 0.75. This project did not have sponsors substantial enough to pursue the deal further. Now there may be a lender out there who is desperate to put loans on the books may close the loan. We call that the greater fool theory. You do not want to be the greater fool.
Back to our example, was the net worth only $500,000? When one looks closer, if the land is free and clear, not listed on their personal balance sheet, and if their money they are putting into the deal as equity is not generated from other borrowers, that would be $2.5MM will be equity. If we add that to the $500,000, they at least have $3MM of equity. It still falls woefully short of the loan request, but at least it looks a little better. We refer this to a case where this shade of lipstick looks better on the pig than it did in the beginning! But it is still a pig. The ratio is 0.40 and the request appears to be seriously flawed!
What does the ratio tell you? If the sponsors do not have adequate net worth, or assuming the personal financials represent inflated equity numbers, the guarantors will not have adequate resources to help either with as cash from liquidity on the balance sheet, borrowing against an asset with equity, or cash from the equity of an asset that would be sold. If something goes south on the project, the lender is stuck with finishing the project or foreclosing.
Is this ratio set in stone? Say you are close on a deal with a ratio of 0.85. Perhaps most of the net worth is from unencumbered liquidity. Maybe they have strong income, very low personal debt service, and a large amount of equity in marketable real estate with a very low leverage. The lender should ask, “How easy is it for the sponsor to put more money into the project if necessary?”
I have seen cases where the ratio is good, but the equity is from a large array of partial interests in other real estate projects that are all highly leveraged. If this sponsor were required to bring more cash to the table, he would have had difficulty since he did not have the power to leverage the properties on his own and if he did, it would require quite a few properties to be pledged to generate any substantial amount of liquidity injection.
Like all other ratios and guidelines in commercial lending, no one is the cure-all to answer all your risk questions. Each one, when used appropriately, can offer insights into the financial situation of the various players in your credit.