Using Letters of Credit to Improve Your Company’s Liquidity

Financial institutions can provide letters of credit (LOCs) which guarantee payment. These documents reduce risks by protecting buyers and sellers engaged in transactions to buy or sell property.

Impact of the COVID-19 Crisis on CRE

In late March, the Commercial Real Estate Finance Council (CREFC) requested that the Federal Reserve and Treasury Department extend their policies to inject much-needed liquidity into the commercial mortgage-backed security (CMBS) market.

According to a report from Deloitte Insights, Balance sheets, capital availability, and liquidity were at healthy levels in early 2020. But COVID-19 has dramatically affected CRE fundamentals and operations — including liquidity. In fact, many property owners have faced short-term liquidity management issues because of delayed rent collection or increased costs.

Leasing volume has decreased, too. In fact, some submarkets — like Manhattan, NY — saw a 25% YOY decline in leasing volumes. Rising uncertainty and valuation worries have slowed new investments. A March survey conducted by Pension Real Estate Association indicated that 74% of respondents have paused CRE investment plans.

Based on early disruptions in the CRE market caused by the pandemic, a survey of capital markets professionals conducted by CBRE learned that:

  • Over 50% saw sellers delay bringing assets to market
  • Over 70% expected more of the disruption to continue
  • The size of bidding pools contracted, with 65% shrinking and 80% expected to shrink further
  • 50% of buyers asked for price reductions and of those buyers, two thirds asked for a 5% reduction

CRE and real estate investment trust (REIT) companies have focused on short-term liquidity management since the beginning of the pandemic. They’re taking steps to preserve cash by delaying/ suspending dividend payments, drawing on credit facilities, exploring refinancing options, and establishing new/expanded facilities and debt offerings to maintain liquidity.

Improving Liquidity in a Post-COVID-19 World

A letter of credit offers a workable alternative to improving liquidity. LOCs can also enhance earnings and grow margins when used as collateral to secure deposits and meet pledging needs. LOCs may allow companies to reallocate securities into options that more effectively meet earnings and asset/liability requirements.

Several types of LOC may be appropriate, based on the type of transaction.

  • Irrevocable: Buyers can cancel or amend the LOC as long as both parties agree
  • Confirmed: These LOCs add more security, stipulating that if the buyer’s issuing bank doesn’t pay the requested amount, the seller’s bank will guarantee payment.
  • Transferable: This type of LOC is used when multiple parties are included in the LOC or the transaction includes intermediaries. The seller’s bank may use this letter to reduce the risk of transaction to the bank.

Why Use a Letter of Credit?

Many commercial real estate investors might not have the net worth or liquidity to satisfy proof of funds. A letter of credit is legally binding, cannot be revoked, and thus ensures a secure method for a transaction.

For many clients seeking to acquire or leas commercial real estate, their working capital isn’t always accurately determined. Businesses that pay for moving costs, marketing, equipment recalibration, and other non-property-related expenses with existing working capital may find themselves cash poor.

Companies that need one of these letters should contact their bank’s commercial division or international trade department. The bank acts like a “disinterested” third party, remaining neutral and releasing funds only after everyone has met specific criteria.

Key Takeaways

A bank or financial institute will send a letter of credit to a seller guaranteeing the on-time, full payment receipt of a buyer’s payment. Many different LOC options exist, including a revolving letter of credit, confirmed letter of credit, and more.

Although a buyer might not have the necessary collateral requirements or relationship with the seller’s bank to secure a LOC, banks do. And because a LOC is opened with a full amount of a transaction, your company’s liquid assets aren’t tied up or at risk.

If you need guidance on how to gain more liquidity, talk to CREA United member Lisa Wagner, VP of ConnectOne Bank, Pete Rosas, Senior Business Banker/ VP of Capital One Bank, or William Schmid, VP of Provident Bank, or Matthew Putnam, SBA Business Loan Specialist at Dogwood State Bank.

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