OCC Bulletin on Real Estate Lending

A few weeks ago, the OCC posted an Interagency Statement on Prudent Risk Management for Commercial Real Estate Lending.

The agencies seem to be noting increased concentrations and risk in commercial real estate lending activities.  This probably does not come as a surprise to most of you.  The bulletin includes a handy PDF document with explanations and additional references to regulatory guidance.

For your reference, the OCC also has a specific page for Commercial Real Estate, which includes additional links.

Adding back Rent in the Debt Service Coverage Ratio

Often, the building where a business operates is owned separately from the business, itself.  The company-owner will typically own the building individually or through an LLC and lease it to the business.

In such an instance, the rent paid to company-owners (either directly or via LLC or other organization) is typically added back to the numerator of the debt service coverage ratio, while the debt service on the property is included in the denominator.

The cash flows of the company are effectively paying the debt service on the property, regardless of the paper trail.  To perform a full and proper debt service coverage analysis, you include the debt service on the mortgage in the denominator and, correspondingly, add back related rent to the numerator.  (Remember, if you include either rent in the numerator or mortgage debt service in the denominator, then you must include the other as well.)

Sometimes it is only appropriate to add back a portion of the total rent:

Example 1: If the total rent is comprised of rents for various properties, you will only add back the rent portion for the properties also owned by the owner of the company, since only that portion is included as debt service.

Example 2: The owner may effectively be distributing income to himself from the company through excessive rent.  If the rent paid by the company is significantly more than the debt service for the given property, then it may be appropriate to add back only the amount of rent necessary for debt service for the property.

Example 3: If a portion of the rent includes cash expenses such as taxes or insurance, then the amounts of each of these expenses should not be added back.  Do not add back rent unless you obtain a financial statement or lease or verify that the rent added back does not include such expenses.

Note also that you should add back rent paid to owners and consider the corresponding debt service even if the loan is from a different bank.  You also add back rent when the company had been renting but is now buying a facility.

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