Do commercial borrowers benefit from bank relationships?
are looking for a relationship.”
are a relationship bank.”
borrowers hear these phrases when requesting a commercial mortgage loan from a
bank; however, in these circumstances, relationship
is really just a marketing-friendly code word for compensating balance.
balances are funds that a borrower is required to keep on deposit in a bank to
satisfy the terms of the commercial real estate loan agreement. Depending upon
the stipulated agreement, the deposit may be held in a checking account,
savings account, or certificate 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 can vary widely.
common belief in commercial real estate finance — especially espoused by bank
loan officers to their clients — is that if the commercial real estate borrower
enters into a compensating balance arrangement with the bank, the borrower will
benefit from a lower interest rate on the loan.
this certainly sounds like a good idea, keeping liquidity on deposit with the
lender in exchange for a lower rate is in fact just the opposite. As we see in
the example below, agreeing to a compensating balance arrangement significantly
increases the effective rate on the loan.
take the following example: A borrower obtains a $5 million loan at an interest
rate of 4.5 percent. The annual interest payments are $225,000. The bank’s
compensating balance requirement is $2 million. In actuality, the borrower is
borrowing $3 million ($5 million loan less $2 million compensating balance).
Thus, the effective interest rate is 7.5 percent.
two most prevalent types of compensating balance arrangements banks use are the
average balance and minimum fixed amount. The average balance arrangement is
most commonly used in commercial banking lines of credit and is calculated on
the average maintained account balance over a set period of time, typically a
30-day average. Normally when insufficient balances go below the agreed-upon
average balance, the interest rate on the loan will increase.
minimum fixed balance amount is most typically used in commercial real 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
average balance — the level of inequity is substantially greater.
single-asset entities being the most prevalent borrowing structure for
commercial real estate, cash held on the balance sheet of these borrowers is
often limited. Because of this, banks most often will look to the financial
strength of the deep-pocket sponsor behind the borrowing entity to satisfy
their compensating balance requirements.
implementation of the agreement is simplified if the sponsor has an existing
depository relationship with the bank. Since the agreement is binding and the
liquidity is restricted, disclosure must occur in the borrower’s financial
statements and the sponsor’s personal financial statement. Oftentimes, the
bank’s compensating balance requirement becomes higher if the amount of
liquidity available is higher, thus further driving up the effective cost of
Risks and Challenges
compensating balance requirements are buried in standard loan agreements. Many
borrowers and principals are unaware that, when signing, they agreed to a
compensating balance arrangement.
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 right
of offset. In the event of default on the commercial mortgage, it becomes
simple for the bank to freeze or set aside the agreed-upon compensating balance
amount. Once done, this cash now becomes restricted and is unable to be
accessed or used. The restricted cash held by the bank may be applied to reduce
the outstanding loan balance.
of the higher effective cost and the risk of having accounts frozen in an event
of default, many sophisticated commercial real estate investors often choose to
borrow from non-depositary commercial mortgage lenders rather than from their
relationship bank. Keeping a commercial mortgage loan separate from deposits is
prudent from both a cost and risk management perspective.
Zorich is a business development officer for
A10 Capital, a full-service nationwide lending business specializing in small-
to middle-market mini-perm commercial mortgage loans. Contact him at