What Is A Compensating Balance

Financing Focus

Off Residue

Do commercial borrowers benefit from bank relationships?

"Nosotros are looking for a relationship."

"We are a relationship banking company."

Often borrowers hear these phrases when requesting a commercial mortgage loan from a bank; however, in these circumstances, human relationship is really simply a marketing-friendly code word for compensating balance.

Compensating balances are funds that a borrower is required to keep on deposit in a depository financial institution to satisfy the terms of the commercial real estate loan agreement. Depending upon the stipulated agreement, the eolith may be held in a checking business relationship, savings account, or document of deposit. These are cash-restricted funds, and the balance required is usually a percentage of the committed loan amount. The amount is negotiable and tin vary widely.

Who Benefits?

The mutual belief in commercial real estate finance — especially consort past banking company loan officers to their clients — is that if the commercial real estate borrower enters into a compensating balance arrangement with the bank, the borrower volition benefit from a lower interest charge per unit on the loan.

While this certainly sounds like a good idea, keeping liquidity on deposit with the lender in commutation for a lower rate is in fact just the opposite. As we meet in the example below, like-minded to a compensating residue organization significantly increases the effective rate on the loan.

Let's take the post-obit example: A borrower obtains a $v meg loan at an interest rate of 4.5 percentage. The almanac interest payments are $225,000. The bank's compensating balance requirement is $two million. In actuality, the borrower is borrowing $three one thousand thousand ($5 million loan less $2 million compensating balance). Thus, the effective interest rate is 7.5 percentage.

The two most prevalent types of compensating balance arrangements banks use are the average balance and minimum fixed amount. The boilerplate residual arrangement is most normally used in commercial banking lines of credit and is calculated on the average maintained business relationship balance over a set flow of time, typically a 30-day average. Normally when insufficient balances go below the agreed-upon average residuum, the interest rate on the loan will increase.

The minimum fixed balance amount is most typically used in commercial existent estate loans. This agreement requires a predetermined minimum balance amount be kept on account at all times. When banks require a set minimum — rather than an boilerplate residue — the level of inequity is essentially greater.

With single-asset entities being the most prevalent borrowing construction for commercial real estate, cash held on the residual sail of these borrowers is often limited. Because of this, banks most often will look to the fiscal strength of the deep-pocket sponsor behind the borrowing entity to satisfy their compensating balance requirements.

The implementation of the understanding is simplified if the sponsor has an existing depository relationship with the banking company. Since the agreement is binding and the liquidity is restricted, disclosure must occur in the borrower'south fiscal statements and the sponsor's personal financial statement. Oftentimes, the banking concern's compensating residual requirement becomes higher if the corporeality of liquidity available is college, thus further driving up the effective cost of borrowing.

Risks and Challenges

Oftentimes compensating balance requirements are buried in standard loan agreements. Many borrowers and principals are unaware that, when signing, they agreed to a compensating balance organization.

The effect of entering into a compensating balance agreement in conjunction with a commercial mortgage can be far reaching and is very risky to the borrower and its principals. The risk is that compensating balances give the bank the correct of start. In the upshot of default on the commercial mortgage, it becomes simple for the depository financial institution to freeze or set aside the agreed-upon compensating balance amount. One time done, this cash now becomes restricted and is unable to exist accessed or used. The restricted greenbacks held by the banking concern may be practical to reduce the outstanding loan remainder.

Because of the higher effective toll and the gamble of having accounts frozen in an outcome of default, many sophisticated commercial existent estate investors often choose to borrow from non-depositary commercial mortgage lenders rather than from their human relationship banking concern. Keeping a commercial mortgage loan separate from deposits is prudent from both a cost and risk direction perspective.

Steve Zorich is a business concern development officer for A10 Upper-case letter, a full-service nationwide lending business specializing in small- to middle-market mini-perm commercial mortgage loans. Contact him at szorich@A10Capital.com.