Small business is growing once again in the U.S. Following the 2008-09 recession, the number of businesses in the U.S. with fewer than 500 employees fell precipitously. By 2013, small business had once again rebounded to 2009 levels.

This spells opportunity for credit unions. Credit unions have long gravitated toward investment real estate as a relatively simple way to do business lending, as the source of repayment on these loans is easy to understand and is generated primarily from rental income. However, lending to operational businesses can add diversity to your loan portfolio. These businesses, such as tire stores, restaurants, or clothing retailers, generate their income by selling goods and services or adding value to the manufacturing process chain.

Census bureau small business figures
By 2013, small business had once again rebounded to 2009 levels

The risks related to investor property income flows generally correlate closely with longer term trends in the local real estate market. Are vacancies going up? Are local population demographics changing? Is population on a rising or declining trend?

With an operating company, the long-term business risks are the same, but there are unique short-term risks as well, such as:

  • Can the owners hire adequate staff?
  • Can they sell their product at a profitable margin?
  • Are costs of labor and raw materials rising?
  • Are new competitors moving into the market?

The collateral risks between investment real estate and operating entities differ as well. For example, a line of credit secured by inventory and accounts receivable can be fully secured one month, and virtually unsecured the following month. The marketability of inventory is highly dependent on its current state in the process and may become stale or obsolete in a short period of time. Lenders need to liquidate receivables quickly; if you wait too long, they may have already been collected and spent by the borrower. Specialized equipment also has its own challenges as it has a limited market and may deteriorate and depreciate quickly.

Because of these differences, each type of lending demands a different approach toward credit analysis. Fundamentally, all loans rely on the good character of the business owners. The credit report and personal financial statement set the tone for the relationship. But a few additional items should be considered:

  • Debt service coverage: When analyzing an investment property non-owner occupied real estate loan, the focus of the analysis should be on the debt service coverage ratio, which reflects your best chance of being repaid on the loan. As long as the collateral is in good shape and market conditions are favorable, repayment is likely. Borrower leverage is not as important, as long as you have strong collateral coverage. Working capital is almost immaterial, and most of these entities can function just fine with a low-balance checking account.
  • Working capital: For owner-occupied real estate and operating company loans, the analysis of the loan, and your risk rating, should be based on a complete understanding of the operating company as your primary source of repayment.

Similarly, the analysis of an operating company line of credit facility should focus mainly on working capital. The purpose of such lines is to help support the company’s working capital needs, and the primary source of repayment will be the turnover of operational assets.

Stick to Your Knitting

For lenders, the bottom line is that the type of borrower and the type of credit facility should drive the analysis and the credit decision. As an organization, you may have expertise in certain types of loans or industries. If that is the case, you should minimize your exposure to those types of borrowers where you have little expertise, or consider outsourcing that analysis to a service provider with experience in that particular field.