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Characteristics of good debt underwriting as explained by Wharton Emeritus Professor Dr. Peter Linneman.
BRUCE KIRSCH: So this speaks a lot to, again, what’s the nature of that particular cash flow stream in that particular property? How diversified is the tenant base, whether it’s a commercial property or a residential property?
You might be in Silicon Valley, and yes, you have an apartment building, but who are all the tenants? Well, all the tenants are people working for dot-coms. And then suddenly, when all of their employers evaporate, you’ve got a big, big problem.
PETER LINNEMAN: You are leasing to someone specifically. And there’s an old phrase, the guarantee is only as good as the guarantor. And when you sign a lease with someone, they’re effectively guaranteeing that they’ll make the scheduled lease payments.
But that guarantee is only as good as the guarantor. And if that’s not a good company, it’s not a solid company, they may be around to pay it. It’s not like all companies are credit quality. But they may not be. And that’s a risk, a serious risk.
It’s one of the reasons, for example, oftentimes in shopping centers, lenders will not treat as income income you receive as the landlord from certain tenants. They just don’t view them as strong enough credit quality. So you may have a million dollars in income from your tenants that may really be occurring, but the lender may only give you credit for $850,000 of that, saying that $150,000 is coming from sufficiently speculative credit tenants, that we’re going to underwrite it as if that income does not occur.
And that can be very frustrating because you say, well, the income’s really occurring. And they’re saying, yes, if it occurs, you win. We just don’t want to get it that if it doesn’t occur, for the reasons you’re suggesting, Bruce, that they’re stuck. And that’s part of what good debt underwriting involves.
BRUCE KIRSCH: And you mentioned how the debt markets, they run hot and they run cold. And I think it’s important for both students and professionals to really understand and appreciate that the pendulum does swing very far both ways. So in a hot ..
PETER LINNEMAN: And fast. Not just far, but fast.
BRUCE KIRSCH: Right. Right.
PETER LINNEMAN: As you know, can go in a matter of months from an abundance of capital to a shortage of capital in that regard, from five people lining up to make the loan to you, to no one willing to make a loan to you at any amount of any nature. It can happen far faster, and that’s a risk.