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The 5 Cs of Credit

November 27, 2010

When I started in real estate in 1988 it was illegal to have a numeric score associated with your credit report. We learned to get a general impression of the company, their leadership and their spending habits by reviewing their trade lines. How they used credit and the consistency of their re-payment. From this we generated a hypothesis of the risk associated with the borrower and made a credit decision.

Since then it has become uncommon to even know what a tradeline is. Today the client is just a number and no amount of cajoling can change that – especially since the underwriter is a twenty something kid just out of college and doesn’t hardly know what a tradeline is!! In college we learned about the 5 Cs of credit. To me they are a much more reliable way to gauge risk than a credit company’s logarithmic formula. Maybe that’s just because I can see the logic behind the 5 Cs while the credit companies won’t divulge their numeric reasoning.

So, here are the 5 Cs:

1) Character – also known as integrity. Does the person do what they say they will.

2) Capacity – the ability to repay. Often based on past evidence and/or a current paystub.

3) Capital – also know as a down payment. Folks are less likely to default if they have skin in the game.

4) Collateral – something of value that the lender can sell if the borrower fails. “The House”

5) Conditions – current market

When I analyze and investment, tenant or overall transaction based on the above, I get a very clear view of the borrower’s current position and I have pretty good instincts into how their behavior will follow. It works for me. And I hope it can be a tool in your analysis tool box.

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