It is important to have an understanding of what can go wrong with a business loan. The focus of this article is on two situations that will have the most severe financial consequences. A loan disapproval at an early point in the application process is not included here because it is not likely to have the immediate financial consequences of the examples provided below. Business owners should be prepared in advance for these problematic circumstances so that they can develop contingency plans.
RECALL OF A COMMERCIAL LOAN
Recall provisions allow the lender to call the loan (forcing the borrower to repay early) prior to the expiration of the loan. This issue is not of concern to commercial borrowers whose business loan does not contain provisions permitting the lender to recall the loan. However many traditional commercial lenders routinely place recall clauses in their loan agreements. The conditions which can trigger a recall will vary but will commonly include periodic review of financials and credit history by the lender. Under these circumstances if agreed levels of income and credit standards are not met, then the bank will typically notify the commercial borrower that they must pay off the loan within a 30-90 day period.
When confronted with a recall notification, commercial borrowers will have little recourse other than to seek refinancing from another lender. In seeking alternative sources of commercial financing, prudent borrowers will eliminate potential lenders who will impose similar recall provisions in new financing. To avoid the recall situation in the first place, commercial borrowers would be wise to consider only commercial loans which will not have recall terms. For commercial borrowers who currently have recall provisions in their commercial financing agreement but have not yet received a recall of their loan, it will be equally wise to consider refinancing their business loan before such a recall occurs so that refinancing is accomplished according to the commercial borrower’s timetable and not that of the current commercial lender.
COMMERCIAL PROPERTY APPRAISAL COSTS AND RESULTS
The commercial appraisal process is lengthy, expensive and relatively uncontrollable in terms of results. In many cases one of the unknowns is how much the appraisal will cost. Unfortunately commercial mortgage appraisal costs can be unpredictable and will approach what many borrowers view to be excessive for specialized commercial properties such as assisted living facilities. Appraisals for a stated income loan will usually be more costly because the lender is primarily depending on credit scores and a sound appraisal to support the loan. These appraisal situations will cost more for commercial properties in rural areas because qualified appraisers may not be available locally. The timetable for completing an appraisal is another potential source of problems, and until the appraiser is selected and commits to a schedule, the completion date is not likely to be known with any degree of accuracy (and this can result in a longer processing period for the loan).
Even though cost and schedule are critical issues, an even bigger issue is the appraisal value that is provided by the appraisal. For example, I have seen instances in which a commercial borrower thought their property was worth $500,000 but the commercial appraiser selected by the lender produced an appraisal with a value of $285,000. While this is not a routine outcome, it is certainly not unusual to receive an appraisal that produces a value that is less than the commercial borrower expects. A similar (but avoidable) problem occurs when a commercial appraisal is not accepted by the lender because the appraiser did not provide an appraisal meeting basic guidelines. For example, a key element of a commercial appraisal is the valuation based on analysis of income. If an appraiser chooses to submit an appraisal based only on comparable sales data even though the lender stipulated in the engagement letter that an income appraisal is required, then the lender will not accept the appraisal (and is likely to refuse even a modified report from the appraiser when they violate such a basic appraisal requirement).
It is important to have an understanding of how the appraiser will be asked to determine value as well as to realize that there might be significant assets which will not even be included in the value. Items such as equipment and furniture are frequently excluded, especially in commercial real estate loans. For businesses such as funeral homes and assisted living facilities, it is very common for the overall business value to be much higher than the real estate value. But an appraisal based on the real estate value will nevertheless exclude the excess business value from the commercial real estate value.
What contingency plans are advisable for the appraisal process? First, be prepared for the appraisal to be more expensive than initially expected and ensure that funds are available to cover this possibility. Second, be prepared for the appraisal to take longer than expected. If buying a business property, the buyer should discuss this possibility in advance with the seller. If refinancing, the owner should not make plans for spending funds until the appraisal has been finalized and the lender indicates their readiness to close the loan. Third, consider in advance what action to take if the appraisal produces a lower value than expected. Fourth, decide if an additional appraisal is warranted (this possibility needs to be considered especially for the situation in which the appraisal is not accepted by the lender).