Debt Standard Checklists for Individual Loans

This article is part of the Debt Policy Series. The first part of the series can be found here.

So far we’ve established broad risk management policies for our entire portfolio. The top level policies are designed to help us defend against broad market risk — true debt management type risks. Unfortunately, I’m not here to tell you that debt management risk is an island that you can completely ignore asset management factors in your policy making.

We have to establish a set of policies that tie our broad debt management risk to our low-level asset management risk. An example of this risk is ignoring your firm’s disposition habits when making debt decisions. What we need then is a checklist of requirements that highlights those cross-sections of debt and asset risk.

Building a Checklist

I’m not going to pretend that this is an exhaustive list of everything you should ever think about. I’m sure just about everyone reading this has a story about an unusual debt provision that came out of left field to bite them. However, I do hope this gives you a good starting point to build a more thorough list based around your own experiences.

I tend to think primarily in terms of interest rate risk management — that being the bulk of my professional background. Much of my checklist is going to be centered around that idea.

Interest Rate Risks

As a commercial borrower, you cannot escape this risk. I like to describe this as going in risk or going out risk — you have to pick one.

Going in risk is when we take on the risk of rates when we enter the loan. Think of this like using floating rate debt (rates could run up on you like they have this year) or purchasing an interest rate cap (I buy an expensive cap in Dec 2022 and a recession causes rates to collapse next year — money spent in vain). In both of these scenarios we take on the rate risk from the outset, but in exchange I don’t have to really consider the impact of prepaying the loan early since the penalties are usually minimal, if there’s a penalty at all.

Going out risk is when we push back the interest rate risk to when we exit the loan. Think about things like prepayment penalties on a fixed rate loan, or terminating a swap. In these scenarios we locked in a fixed rate of interest so I don’t have to think about or manage that risk today, but there’s a risk that it comes back to bite us the next time we sell or refi.

To manage these risks, we want to establish the following checklist items:

Loan Term. This is going to be influenced by your business plan, but take into account your previous habits. How often do you end up prepaying a loan with more than a year of the loan term remaining?
Interest Rate. Also business plan dependent. For shorter term projects I tend to lean floating rate, since the prepayment penalty terms tend to be more flexible. For anything past 5 years, hedging with options can become absurdly expensive, so fixing or swapping the rate tends to make sense. Also consider the effects of interest rate floors.
Hedging Requirements. This will outline whether hedging is required for floating rate loans, what types of hedging instruments are allowed, and what % of the loan must be hedged.
Prepayment Terms. What sorts of prepayment terms do I find reasonable. Recalling our going in or going out perspective on rate risk, if I take on floating rate debt (Going in risk), I want to counter that by avoiding anything beyond a nominal prepayment penalty (Going out risk). You may need to be flexible here depending on the type of loan you’re after.

Economic Terms

As much as I wish this could just be an interest rate discussion, we do have to focus on other terms that start having more interaction with the asset management side of the equations.

Loan Amount. In a checklist form that’s deal agnostic, this is probably more focused on the actual underwriting criteria than the final amount. Take the time here to describe the types of risk you’re willing to take on. For example, if you’re using floating rate debt, you may want to use a DSC constraint that’s more conservative than if you used fixed. You may have different LTV requirements depending on the loan term.
Amortization. Do you have any requirements around the loan amort? For example only considering loans with at least a 30 year amort, and 1 year of UI periods.
Seniority. Are there any instances where subordinated debt makes sense to use?

Loan Governance

There’s cost associated with the covenants you have to comply with. Help provide some guidance on what terms you’re ok with and how you’re willing to comply. Examples include:

Events of Default. This will be based on personal experience. Have there ever been weird EOD’s that you refuse to agree to anymore? How should those EOD’s be cured?
Escrow Accounts. What kinds of accounts are you ok with and what are deal breakers?
Lender Compliance. How often is compliance reporting required? Is financial covenant testing required? How often? Do you have the capability to do it?

Other Terms

Anything else that’s important to you can go here. For example, your Principals may have particular things around the types of Guarantys they’re willing to provide.

Guarantors. What type of Guaranty are your principals willing to provide? How much are they willing to provide? If there are multiple guarantors, are there any limitations to the recourse they are individually responsible for?

You’ll probably end up with several checklists depending on how many asset types you work with and the types of deals you work on. The important thing to keep in mind is that all of these items are just guidelines. There are always exceptions to the rule, which we talk about in the next part of our series, which covers what to do when reality just doesn’t allow us to work within the bounds of our standards and policies.

You can access our Loan Standards Checklist as a starting point for building your own.

This is Part 4 of the Debt Management Policy series.

Next: Setting and Enforcing Debt Management Policies

The Debt Management Policy is a short series of articles that provide the resources and materials for building and establishing Debt Management Policies for your own CRE firm.

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