The Grower as Informed Borrower
If times are good, you likely are anticipating (and dreading) going into town to convince someone to lend you a ridiculous amount of money for land or capital expansion; the more you know about what makes lenders tick, the better your odds of getting the right loan service.
At some point, every commercial grower has faced the daunting question: How do I finance the acquisition of some capital asset (such as land, material handling systems or automation equipment) or fund the expansion of working capital (rising inventory or accounts receivable levels)?
An ever-growing number of lenders offer a dizzying array of financing products (from bullet loans to sale-leaseback arrangements) to meet these needs.
This article is the first of a three-part GPN series intended to provide the commercial grower with basic guidelines on:
• How to navigate through the financing process.
• What to expect from lenders.
• How to negotiate the best financing deal for your company.
Theoretically, a vast array of financing sources are available to the commercial grower, including traditional banks, commercial finance companies, and insurance companies.
However, the appetite of any particular lender for financing various types of assets will fluctuate based on a wide variety of factors, including overall market conditions, prevailing interest rates, and lender familiarity with the general asset type. At the moment, the competition among lenders for "quality loans" is intense, which is decidedly in the commercial grower’s favor.
As a general rule, commercial banks will be the most conservative of the potential financing sources in their approach to lending money. While commercial banks may be more conservative than, say a commercial finance company, banks do offer some advantages.
Specifically, they often offer a wide range of additional services that other lenders may not. Historically, banks have benefited from the "separation of services" imposed by federal regulators (primarily through passage of the Glass-Stegal Act of 1933) to draw a line of distinction between commercial and investment banking services.
However, recent changes in the laws regulating the financial services industry (in particular the passage of the Graham-Leech Bliley Act) should eliminate many of these barriers. The result should be a blurring of the lines of demarcation between traditional commercial banks and other finance companies.
Commercial finance companies will tend to be more aggressive in their approach to lending, offering more flexibility in the terms and structure of the loan. The offset to this "largesse" is that commercial finance companies tend to charge more for their services than do commercial banks.
Some banks, even some insurance companies, have departments that specialize in lending to companies in the agribusiness industry. This specialized knowledge can be very helpful to the borrower because a lender with a firm understanding of agribusiness will be much more familiar with the ups and downs and the seasonality of agribusiness.
Regardless of the type of lender or the type of asset being financed, all lenders ask themselves four basic questions when evaluating a loan request.
• Why does this particular borrower want to borrow the money in the first place? "Investing in an asset that will enhance the underlying business" is a good answer. "Funding the family trip to Barbados" is a bad answer.
• If I make this loan, how will the borrower pay me back?
The answer required will vary depending on the type of lender. Most commercial banks are "cash flow" lenders, meaning that they will analyze the company’s financial statements and business to determine whether or not they believe that the cash flow generated by the business will be sufficient to retire the debt over an agreed-upon term.
Most cash flow lenders will want to see cash flow/debt service ratio of at least 1.25:1. In other words, the lender will feel comfortable making the loan if the anticipated cash flow generated by the lendee’s business exceeds the cash needed to service the debt by at least 25 percent.
Other lenders such as commercial finance companies tend to rely more on the value of the collateral they take to secure the loan. The rationale is that even if the borrower doesn’t pay, the lender can seize the collateral, liquidate it, and retire the debt.
• Assuming the borrower repays this loan, am I going to make money under the proposed loan structure?
Most commercial lenders, whether they work for a bank, an insurance company or a commercial finance company, are evaluated on the profitability of the business they generate. Consequently, the lender wants to believe that the loan is profitable, or will at least form the basis of a long-term profitable relationship.
• Do I trust the borrower?
Every lender knows that no matter how good the borrower’s business or how well-secured the loan, a dishonest borrower intent on defrauding the lender will prove a formidable opponent. Beating these people in court is far from a given. As George H. W. Bush once said, "Character counts!"
Assuming that your potential lender feels comfortable working with you on a loan – whether for land acquisition, equipment, physical plant or working capital – the first rule of thumb when dealing with financing sources is that everything is negotiable. Most borrowers tend to focus too much on the rate and not enough on other loan terms such as prepayment penalties, closing costs and payment terms.
For example, if a grower were to finance a $125,000 piece of equipment by putting down $25,000 and obtaining a loan for $100,000 payable in monthly installments over five years, the difference in the monthly payment between a 8.50 percent rate and a 9.0 percent rate on the loan is only about $24 per month ($288 per year). The borrower might, for instance, save thousands of dollars if he or she can persuade the lender to drop the prepayment penalty.
Lenders who are not willing to negotiate on particular terms or structuring issues generally will tell you; however, these instances are not common.
As you negotiate with a lender, try to hold in your mind the lender concerns I just discussed. Having anticipated these concerns, you can frame your requests and negotiate with a better level of understanding.
The second rule of thumb when dealing with financing sources is to always read the documents thoroughly before signing. I can’t tell you how many times I’ve sat in front of borrowers after handing them loan documents only to watch in horror as they signed without reading a single word. Poring over loan documents is tedious at best, but believe me, it’s a necessary evil. While you and the lender may have agreed on the general terms long ago, the reality is that your lender is probably not the person who prepared the documents.
Miscommunications between lenders and the people who prepare the documents are not uncommon. Sometimes this can work in your favor, but is that a risk you are willing to take? Likewise, while you and the lender may have agreed on the general terms of the loan, you invariably will encounter additional terms in the loan documents that were not specifically covered in your discussions with the lender.
One of the most common financing situations encountered by the commercial grower is the borrowing of money to purchase land, whether it’s raw land upon which the grower intends to construct greenhouses, or land as a part of the acquisition of an existing commercial growing operation.
Advance Rates: As a general rule, most lenders will lend a borrower up to 65 percent of the lesser of the purchase price or appraised value for raw land (undeveloped land without improvements such as water and sewer connections), and up to 80 percent of the lesser of the purchase price or appraised value for developed property.
There are lenders who will advance at greater percentages, but typically the cost of such borrowing increases dramatically in comparison to borrowing at standard advance rates. Some lenders will also consider advancing greater than 65 percent or 80 percent with the provision of additional collateral or a personal guarantee from the principle of the business.
Appraisals: Regardless of the purchase price, the reality is that most lenders will want to have the property to be acquired appraised by a certified appraiser acceptable to the lender. In the case of commercial banks, the Financial Institutions Recovery, Reform, and Enforcement Act of 1989 (commonly known as "FIRREA") requires that a bank must obtain a certified appraisal on the property before making a loan secured by real estate equal to or greater than $250,000.
The appraiser used by the bank will be one known to the bank and one whose work and methods have been approved by the bank’s board of directors. FIRREA requires that the appraiser follow the Uniform Standards for Professional Appraisal Practice ("USPAP") when appraising property.
Typically, appraisers will approach the value determination on a particular piece of property using three methods: the cost approach, the income approach, or the sales comparison approach.
Depending on the circumstances surrounding the particular piece of property to be acquired, one or more of the three approaches may not be applicable. For example, the income approach is typically not used in residential appraisals, as most residences are not income-producing properties.
At the conclusion of the appraisal, the appraiser will then reconcile the applicable approaches and come to a final value conclusion.
For commercial properties, most appraisers will use the income approach as the primary determination of value. Under the income approach, the appraiser will determine the amount of revenue generated from the property, deduct expenses (which include a vacancy factor and management expense), and derive an annual income projection for the property. Once the income level has been determined, the appraiser will divide the income amount by a capitalization rate and determine the overall value.
Effectively, this means that the appraiser is placing a value on the expected cash flow stream the property will generate. The capitalization rate that the appraiser will use reflects current market conditions, including demand for similar properties and expected rates of return. For a commercial property, this approach typically receives the most credence in the appraiser’s final reconciliation value.
Under the sales comparison approach, the appraiser will look for similar or comparable properties in the area that have recently sold and compare them to the property in question. After comparing the particular features of the property to the properties that have been sold, the appraiser will adjust the value of the property to be acquired accordingly. For example, the value of the property to be acquired likely will be increased if it is larger than a comparable property with a confirmed sale. The sales comparison approach is the most common approach in the appraisal of residential real estate.
When applying the cost approach to valuing property, the appraiser determines what it would cost under current market conditions to acquire the property and also to construct the improvements (buildings, etc.) on a particular piece of property. In most appraisals the cost approach receives the least amount of credence in the final value reconciliation.
For commercial properties, most lenders also will require some sort of environmental review of the property. This will likely encompass what is known as a "Phase I" Environmental, which requires that a certified environmental examiner inspect the property for signs of potentially sensitive environmental issues such as underground storage tanks (UST’s), vent pipes that suggest evidence of UST’s, or potential asbestos-containing materials.
The examiner also will conduct extensive research into the property’s history, poring over public records for any indication of environmental issues (i.e., a gas station or dry cleaning operation previously located on the site).
While the lender "hyper-sensitivity" to environmental issues characteristic of the late eighties and early nineties has subsided, lenders are still attentive to potential environmental issues.
When financing the acquisition of land, most lenders will require that the borrower have title insurance on the property. Title insurance provides coverage against a third party making a claim of ownership against the property you are acquiring. In addition, if there is a claim, the title company will defend the claim for you (i.e., provide an attorney).
Regardless of whether the lender requires it, obtaining title insurance is an excellent idea.
If you are acquiring property, title insurance will come in two forms. The first is an owner’s policy that protects you, the buyer, from any claims against the title to the property. The second is a lender’s policy that protects the lender against any claims on the title to the property.
There is some good news and bad news about title policies. The first piece of good news about title policies is that when you purchase property, the seller of the property customarily pays for your owner’s policy. The bad news is that you, the buyer, will have to pay for the lender’s policy.
But don’t despair! There is some more good news – of the two policies, the lender’s policy should be considerably cheaper.
A cautionary word regarding title insurance: Be sure that you are comfortable with the title company issuing the policy. There are numerous title companies out there, but not all are on sound financial footing. Any title company worth a salt should be willing to share its balance sheet with you so you can make a judgment about the company’s relative financial strength. A title policy is only as good as the title company’s ability to defend you in the event of a claim, and to pay out if the claim is successful.
When financing land acquisition, most lenders will require that the borrower pay the closing costs out of pocket. Closing costs will include attorneys’ fees, appraisal cost, title costs, environmental assessment costs and a potential myriad of other costs.
A good lender should be able to provide you with an accurate indication of what to expect. Be forewarned: Closing costs can be sizable! Commercial appraisals can run anywhere between $800 and $5,000 depending on the size and complexity of the project. It is not uncommon for environmental reviews to run up to $3,000.
Careful negotiation can save substantial dollars in closing costs. One effective technique is to request that the lender cap the closing costs at some specific dollar amount. This is particularly effective as it relates to attorneys’ fees. As the buyer, you are not the client (the lender is), so you have little leverage with the attorney. Unfortunately, attorneys may be less conservative with their billing practices when they know somebody other than their client is paying.
In the next article of this series I will discuss the financing of material handling systems, automated equipment and other capital equipment, focusing on the issues a borrower will face and how to negotiate with a lender.