When it comes to securing capital for construction projects or land acquisition, understanding the concept of borrower liquidity is vital for success. In this context, liquidity refers to the financial resources and readily available funds a borrower has on hand to safeguard against unforeseen challenges, such as cost overruns and construction delays.
The Role of Liquidity
Even the most meticulously planned construction projects can encounter unexpected challenges. Bad weather, gas price increases, inflation, or supply chain disruptions can cause delays and unexpected cost overruns. In such situations, having a source of readily available funds, known as liquidity, can make all the difference between a successful project and failure.
The 5-10% Rule
When evaluating borrowers for construction or land loans, Enact Partners looks for liquidity equivalent to 5-10% of the loan amount. Additionally, there is typically a 5-10% contingency already factored into the loan budget. Such a dual approach ensures that borrowers not only have the means to handle anticipated expenses but are also prepared for the unexpected.
The 5-10% liquidity requirement might seem arbitrary, but it has a solid rationale. First, it ensures that borrowers have a significant financial stake in the project. Second, it demonstrates borrower commitment and their ability to absorb moderate shocks to the budget.
Requirements for Liquidity
As part of our lending due diligence, Enact Partners scrutinizes sources of borrower liquidity to gauge overall financial strength and the borrower’s ability to navigate uncertainties that often accompany commercial real estate projects. What we typically look for includes . . .
Cash Reserves—The most straightforward form of liquidity is cash or cash-equivalents, such as readily accessible savings accounts, money market funds, or short-term certificates of deposit. These assets can be quickly converted into cash to cover immediate needs.
Lines of Credit—Borrowers may also use lines of credit as a source of liquidity. We evaluate the terms and availability of these credit lines to ensure they can be accessed in a timely manner if necessary.
Investment Portfolios—Some borrowers may have investments, such as stocks or bonds, that can be liquidated to provide required funds. During the loan application process, we assess the ease and speed at which these assets can be sold. Note: investments in retirement accounts such as 401ks or IRAs are not considered liquid.
Personal Guaranties—In some cases, borrowers may offer personal guaranties to demonstrate their commitment and willingness to use personal assets if the need arises. While not strictly liquidity, it adds a layer of security.
Track Record—We view as favorable a borrower’s history of successfully completing similar projects. Such a track record can indicate an ability to manage liquidity effectively.
Implications of Liquidity
Understanding the implications of liquidity in commercial real estate lending is crucial for both borrowers and lenders. Let’s explore how this requirement affects each party.
For Borrowers . . .
- Competitive Advantage: Having sufficient liquidity can give borrowers a competitive edge when seeking financing. It showcases their financial strength and commitment to the project, making them more attractive to lenders.
- Risk Mitigation: Liquidity acts as a safety net. It ensures that borrowers can address unexpected challenges without jeopardizing the project’s viability or their financial well-being.
- Flexibility: Liquidity provides flexibility in decision-making. It allows borrowers to adapt to changing circumstances or seize new opportunities that may arise during a project.
For Lenders . . .
- Reduced Risk: Lenders benefit from liquidity requirements as it reduces the risk of default. Borrowers with ample liquidity are better positioned to honor their obligations even in challenging situations.
- Stability: A well-funded borrower is more likely to complete the project, reducing a lender’s exposure to incomplete or abandoned projects.
- Enhanced Due Diligence: Liquidity requirements necessitate a more thorough due diligence process. Lenders scrutinize a borrower’s financial health and project feasibility in greater detail, which can lead to better-informed lending decisions.
An Important Part of Our 10-Year Record of Success
Liquidity is an important part of Enact Partners’ due diligence. It allows us to ensure borrowers have the necessary financial means to support their construction projects and mitigate potential risks associated with land acquisition. As such, liquidity often acts as the linchpin that ensures project success and financial stability.
Contact Us About Your Borrowing Needs
(760) 516-7776 | [email protected] | www.enactpartners.com