Restaurant Loan Story – Part III

The Restaurant Loan Story – The Resolution

Remember when I said that commercial lending is more art than science, well that also applies to downside scenarios. There is no established way to do downsides scenarios. There are literally dozens of ways I could have taken this restaurant loan request to stress the projected debt service coverage. I could have assumed that the restaurant revenue would be lower, I could have changed around the cost structure of the new restaurant, or assumed much higher interest rates.

Funny story about downside scenarios,  I remember during the boom years  when I was underwriting some construction loans for new condominiums. Our procedures when looking at a new project involved hiring a commercial appraiser to give us an estimate of value, and an estimate of how quickly the units will sell (absorption). Since we did not really have a procedure as to how to do downside scenarios, I just got into the habit of taking the appraiser’s absorption forecasts, and dividing them by half.  If the appraiser said that you could sell 6 units a month on a 60 unit project, my absorption downside was 3 units a month on a 60 unit project. By using this rule of thumb, I was essentially doubling the repayment period of the loan. If the repayment was still there with the slower absorption, I considered the request to have passed the test. The funny part of the story was that the lenders would often complain about my downside assumptions being too strict, and how it was unthinkable that the project would not sellout at the rate that the appraiser estimated. In reality, we all know what happened, the projects ended up selling only one unit every six months, and the projects failed.

Anyway, we were talking about mitigating the concerns of the credit officer regarding the new restaurant loan, and coming up with a sensible downside scenario. To come up with an approach that made sense, I tried to think what would be the worst possible thing that could happen, and how will it affect our repayment.

I ended up realizing that the worst thing that could happen was that the new location would prove disastrous, and after a few months of losses and little traffic our borrower will give up and close the doors of the new place.

Now that I had a premise, I needed to know how that premise would affect the borrower’s ability to repay. The bank would still require payment, and the lease was a legal agreement that would still require payment, but other than that there was no food expense or operating expense associated with the new location. So I came up with the following downside scenario using only the cash flow from the original location.

In Thousands of US$

Downside

Net Income

$240

Depreciation

$50

Interest Expense

$48

Lease Expense new Restaurant

($100)

Cash Available to Service Debt

$238

Existing 504 loan P&I

$37

Existing SBA 504 loan P&I

$28

Proposed Facility P&I (7.5%)*

$78

Total Debt Service

$143

DSCR

1.66X

Cash After Debt Service

$95

As you can see, the cash flow is still there even in the downside scenario. My friend added my tables and reasoning to his credit approval memorandum, and the new restaurant loan was approved.

About a week ago I talked to my friend again, and I asked him for an update on the restaurant loan, and he told me that he closed the loan, and that the new location opened at the beginning of the year. The happy ending is that the new location is much busier than the owner himself thought it would be surpassing the old location by a lot. Just goes to show you that a loan request that someone might think difficult to do might be easier if the borrower and lender are flexible enough.

This does not mean that I think restaurants are a good credit risk, more than likely they are not. However, this one was different. We had the benefit of:

  1. -      An experienced operator
  2. -      The original location with great cash flow
  3. -      Premium location
  4. -      Substantial equity contribution

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