by Nick Reynolds, VP/Credit Services Manager
The risks associated with business lending differ significantly from those associated with traditional consumer lending. While consumer information is still an important part of knowing your member, the types of risks associated with commercial loans tend to be more varied and wider in scope. This article is one in a series to help credit unions more clearly understand some of the unique risks of business lending.
Appraisals are an important piece of your business lending program for several reasons. To begin with, they are required under current regulations. Appraisals must meet certain conditions and provide a value that is completely independent. Beyond the compliance aspect, appraisals help to protect both you and your member, and are a core factor in assessing what is typically a major item of collateral.
There are a few things, however, that can create problems in an appraisal. One of the most common is the determination of business value. In its guidance, the National Credit Union Administration (NCUA) prohibits the use of a so-called “going concern” business value in appraisals.
In practice, appraisers often have a difficult time separating going concern value from the “pure” real estate value. This is particularly true in single-use facilities, like bowling alleys, car washes, gas stations and convenience stores, hotels, water parks, golf courses, and movie theaters. Many appraisers like to include going concern business value, as it makes their overall analysis easier. On such single-use properties, you might want to consider including a specific clause in your engagement letter requiring the exclusion of going concern value.
Beyond going concern value, you can consider equipment and personal property values in your collateral pool, but should do so with thoughtful consideration. NCUA guidance requires, at least, that those values are separated in the appraisal so you can make an accurate determination of their value as collateral. In cases where the personal property is a significant portion of the value, you may want to lend on those separately, where you can use a shorter amortization to allow for the shorter life of the asset. A general principle of lending is to match the life of the loan with the life of the asset, and this detail in the appraisal will make that possible.
The primary goal of the appraisal is to provide an “as is” value, and this is where your underwriting should be focused. You may consider prospective values, projections, and market rates, but when it comes time to fund your deal, your collateral is worth only what the appraiser has valued it at today. The amount of value you recognize for all of those future events is based on your knowledge of your borrower, and your confidence they can execute their plan.
There are a number of ways to determine value. The three most common methods are the cost approach, the sales comparison approach, and the income approach. Some lenders use a discounted cash flow approach, but this method makes a lot of forward-looking assumptions. If your borrower has long-term leases with escalation clauses, the discounted cash flow approach may be justifiable. However, be aware that this is the most common method of determining business value, and as we discussed, that is not an element you are allowed to recognize as collateral value.
A complete and well-supported opinion of value is a critical piece of your underwriting process. But do not rely on it solely at the expense of your own judgement and knowledge of market conditions. The appraisal contains many pieces of valuable information, but your knowledge of your local business and real estate markets is your biggest safeguard against overvaluing your collateral.