Image of a contractor with a hard hat and holding plans outside and walking towards a residental property

Business Lending to Contractors

By Nick Reynolds, Vice President/Credit Services Manager of CU Business Group, LLC

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.

Lending to contractors can present some unique challenges. Contractors are often desirable members that carry large-balance deposits and loans, are a critical catalyst for community revitalization, and can be a good source of referrals. Additionally, the residential and commercial construction industries have rebounded strongly from the late 2000s recession. However as borrowers, contractors come burdened with certain risks, and it pays to be sure you understand these risks prior to getting in too deep.

Value for Construction Put In Place, Source: U.S. Census Bureau

For the purposes of this discussion, we refer primarily to general contractors that do major projects, as opposed to trade contractors. Generally speaking, you can analyze trade contractors such as plumbers and drywall installers just like regular operating companies. However, contractors that use progress billings, account for their work on a percentage of completion method, and employ a bonding company, present much different risks.

Progress billings, whereby a contractor’s customer agrees to pay in installments as the work is completed, are common in the industry. However, be aware that such billings do not count as receivables on the balance sheet. Nor are they legally enforceable under a security agreement and UCC filing. From a practical standpoint, progress billings may not be collectible either, because if the job isn’t completed or is done incorrectly, the contractor won’t be paid.

The percentage of completion method of accounting is useful in estimating the borrower’s income, and a detailed work in process schedule should be obtained from any contractor you lend to, along with other standard financial information. The calculation of income is typically based on an amount of costs spent versus costs incurred ratio. For instance, if the contractor has spent 90% of the cost of a project, it is considered 90% complete, and you can recognize 90% of the anticipated income. But note that this doesn’t consider retentions that may not be paid for months, or at all, cost overruns, or other variances in income. Tracking the percentage of completion is valuable in understanding your member’s current financial condition, but an in-depth knowledge of the borrower and of the projects they are involved in is fundamental to understanding the risk. For example, who is providing the funding for your member’s construction project? It is not unheard of for a general contractor to begin a project, issue progress billings, and then not get paid because the customer didn’t have their financing in place. This is also a good reason not to provide lines of credit to a contractor. If they build for someone with construction financing, they shouldn’t require use of a working capital line. On the flip side, if the contractor offers financing to her customers, as the lender you should only finance one project at a time, giving yourself the opportunity to review each project on its merits.

Bonding presents its own issues. If your member can’t complete a project, the bonding company steps into their shoes. While the bonding company is generally in a subordinated lien position to your credit union, the practical effect is that the bonding company controls the process and determines who will get paid and when. You can be sure they won’t pay you before they reimburse themselves.

One of the more formidable risks common to all contractors is how much of their success relies on the individuals in their operation that are responsible for the bidding process. Most contractors are fairly adept at estimating project costs. But it only takes one missed estimate on a bid to potentially create a huge cost overrun. This may be the single most likely area for a contractor to create a big problem, and there is little you can do to prevent it. The best way to deal with this is to be sure your borrower has a significant amount of equity in the business to help them weather any single adverse event, and to discourage them from taking on projects with which they don’t have much experience.


What is Holding Back the Development of Comprehensive Business Services in US Credit Unions?

By Adam Szymanski and Donnie Maclurcan

Adam is a researcher at the Post Growth Institute. Donnie is a co-founder of the Post Growth Institute and an Affiliate Professor of Social Science at Southern Oregon University.

The institute behind this research is seeking a small amount of funding to enable the next stage of this study. They are also looking for credit union employees interested in completing a short survey and/or being interviewed about commercial capabilities. The researchers can be contacted at info@postgrowth.org.

Abstract

The credit union movement has experienced rapid growth across the United States in recent years. After the financial crisis of 2007-2008, US credit unions emerged more resolutely as trusted financial partners, able to maintain lending during the credit crunch and offering better loan and deposit rates, greater investment security and superior customer service. Credit unions are known for their focus on consumer banking. Yet this has obscured their changing relationship with businesses.


This paper seeks to discover the state of US credit union capabilities with respect to business banking services. After creating a classification for the level of US credit union business banking capabilities, we conducted informal, semi-structured interviews with a small sample of key stakeholders from the US credit union industry in order to provide insights into the nature of existing US credit union business banking capabilities.


Since US credit unions have been shown to provide direct economic benefits from consumer banking, along with a positive track record for small businesses, we are interested in credit unions’ potential to serve larger businesses beyond the provision of loans. Given that businesses have higher average deposits than consumers, there is potential for shifting significant resources from banks to credit unions.


Our findings suggest that while many US credit unions offer Basic Business Services, and some US credit unions offer Semi-comprehensive Business Services, no US credit union offers Comprehensive Business Services. We discovered three main factors holding back the development of these commercial capabilities: mission constraints; lack of apparent business demand; and lack of a strong business case according to a cost-benefit risk analysis. These factors appear to reinforce each other in a vicious cycle.


However, these factors may also present points of leverage for those seeking to expand business service capabilities within the US credit union system. For example, if weak business demand stems from an absence of targeted marketing to the private sector, a campaign to document pledged allegiance could reverse this phenomena. Indeed, we see strategic interventions at one of the three points offering the ability to shift the system from a vicious cycle to a virtuous one.

Szymanski, Adam and Maclurcan, Donnie, What Is Holding Back the Development of Comprehensive Businesses Services in US Credit Unions? (October 18, 2018). Available at SSRN: https://ssrn.com/abstract=3269580

Consistency and Oversight Critical in Financial Spreading

By Nick Reynolds, Vice President/Credit Services Manager of CU Business Group, LLC

The use of spreadsheets is standard practice in the analysis of any business loan.  Spreadsheets allow for the presentation of financial information in a consistent, standardized way within your credit union, so that all persons associated with the approval and review of loans are on the same page.  In addition, the use of spreadsheets is fundamental to a full and complete analysis of your borrowers, since they provide uniform treatment of ratios, as well as a consistent presentation among years for an individual borrower.  This year to year presentation is imperative for tracking all developing trends and changes in business conditions.

Today, there are a number of automated spreading tools available through cloud-based end-to-end commercial loan origination systems. Several of these tools are excellent, and provide a level of consistency and efficiency that is missing from traditional, manual spreadsheets. However, regardless of which tools are used it is critical that personnel have a solid understanding of the process.

Often, business lending shops will assign the spreading or credit analysis function to the newer members of the team, and as such it is valuable as a training tool.  But because spreading represents the foundation of the entire analysis, it is important to get it right.  This does not necessarily mean that figures from the tax returns should be transferred directly into the same line on the spreadsheet every time.  It should not be simply a mechanical process done by rote.  Spreading should utilize the same thoughtful input as underwriting.

Take for example, so-called “unusual items” on the borrower’s income statement, which may include items such as a large distribution or the gain on sale of an asset.  Such items are typically non-recurring, and the analysis should take that into account.  The best way to do that is to adjust it in the base spreadsheet, so that it will automatically translate to all down-process derivative spreadsheets and calculations.  But to do this, the entry-level spreading analyst must be on the same wavelength as your underwriting staff, which means the analyst needs to think like an underwriter.

Similarly, consistency is the hallmark of a good spread.  Experienced underwriters would rather see a statement spread incorrectly but consistently than correctly but inconsistently.  Changes in the analysis of a borrower that are due solely to the inconsistent application of varying spreading methodologies are not acceptable.  For example, examiners look askance if a relationship is downgraded simply because this year a “Due from Related Party” account was categorized correctly as an intangible asset, whereas it was incorrectly categorized in prior years. For all adjustments, the analyst needs to decide if leaving the spread incorrect is not material to the analysis, or if it needs to be re-categorized because it has a significant impact on the analysis.

The proper spreading of financial statements is a learned skill that takes time and experience to master. However, reality dictates that most credit unions have their spreads done by newer, less experienced analysts.  Because of this, it is critical to employ regular, engaged oversight of the spreading function, to ensure that this critical role is being performed in a consistent and high-quality manner.


Close-up of a dial showing high risk

Managing Risk After the Business Loan is Made

By Larry Middleman, President/CEO, CU Business Group, LLC

The business loan documents are signed and the funds distributed. That means your job is done, right?

Wrong. Due diligence and risk management are crucial steps after the business loan is made. Proper risk monitoring over the life of the loan is essential to identifying potential problems before they occur and early detection is the best way to fend off problems before they become big issues. 

Effective risk management practices also allow for frequent ‘touches’ of the loan in an efficient and cost-effective manner.  The days of simply doing an annual review on a business loan are long past.  As the late-2000s financial crisis amply demonstrated, conditions can change rapidly.

A Scaled Approach

In our work with credit unions across the country, we see many examples of excellent business lending risk management practices.  We also see credit unions where risk monitoring is non-existent.  In recent years, regulators have stepped up their oversight in this area, so be prepared for a rigorous review of your risk management practices in your next exam.

My view is that monitoring activities should scale depending on the general riskiness of the loan.  Important factors include the dollar amount of the loan, the type of loan, and the borrower’s industry.  Higher risk loans include lines of credit secured by accounts receivable or inventory.  Certain industries, such as retail and hospitality, often carry higher than average risk.

Many credit unions take an all-or-nothing approach to risk monitoring, e.g. “we only monitor loans over $250,000”.  While this attempts to balance monitoring efforts with the associated cost, in most cases a more thorough approach is warranted. 

I believe the right framework for credit unions is to adopt a risk management system for their business lending portfolio.  This holistic view encompasses all the key elements of risk monitoring, both on an individual loan basis and on the entire business loan portfolio.  Here are the fundamental steps in establishing a risk management system in business lending.

Tracking

Management must put a process or system in place for timely and effective follow-up.  A ‘tickler system’ is the best tool for setting key follow-up dates.  A typical follow-up activity would be sending a letter to the borrower requesting updated insurance records.  The trick is to re-set another tickler for two weeks later to ensure the insurance information has been received.  Simply sending the letter is not effective risk monitoring – actually receiving the information and analyzing it is true risk management.

Today, with the advent of cloud-based loan operation systems, tracking and follow-up is easier than ever. Automated tickler alerts can be set up that will email a notification to the loan officer, or even directly to the borrower.

Analyzing the Borrower’s Financial Condition

The fundamental activity in risk monitoring is reviewing the borrower’s financial situation. This will identify changes in condition as compared to the original underwriting and subsequent reviews of the loan, a key to identifying potential problems before they arise. You may notice that a borrower has had a decrease in sales or unusually high expenses, and that is the time to talk with your borrower. 

Global Cash Flow Analysis

It is critical to understand your borrower’s other obligations.  Other projects or commitments that go bad may drag down the performance of your good loan.  This takes expertise and resources, but again – early detection and fast action are the best methods of warding off loan losses.

Monitoring Industry and Market Conditions

When dealing with commercial real estate, look at the market conditions for the property. Are rents in the area rising or declining?  What are the occupancy trends of comparable buildings?

Consider the macro view of your member’s business. Will industry-related government regulations affect the company? Will potential state or federal taxes increase the price of the firm’s product or service?

Stress Testing

Stress testing is a tried-and-true method of identifying the key areas to watch for during the life of the loan.  At what point would the debt coverage be less than sufficient to support your loan payments?  How low can the lease income or occupancy rate go before there are potential problems with the cash flow of the property?

Multiple Touches

Automated risk monitoring solutions exist which allow for cost-effective loan monitoring between annual reviews.  We recommend at least two ‘touches’ of the loan in addition to the in-depth annual review.  These touches might identify certain situations, such as: Has the borrower’s or guarantor’s credit score recently decreased?  Are there any environmental issues with a property adjacent or near to your collateral?

Monitoring the Overall Portfolio

Credit unions must also step back and view the forest (the business loan portfolio) and not just the trees (the loans).  Does your portfolio have excessive concentrations in one loan type or industry?  What is the weighted-average risk rating of your portfolio?  What is your exposure relative to the credit union’s net worth?  Management must take the macro view to complement individual loan monitoring.

Reporting

I see it all the time…management believes the right things are being done, but they really don’t know – and sometimes they only find out when it is too late.  Proper management and board oversight is only accomplished with thorough and complete reporting from the business lending area of the credit union.  An effective risk management system includes a continuous feedback loop to keep everyone apprised of both the positive and negative aspects of the business loan portfolio.

As with individual loan tracking, systems exist today that take much of the manual effort out of portfolio monitoring and management reporting. Operational managers as well as senior executives and board members can have real-time access to detailed, easy-to-read dashboard reporting. Such reports can display information as varied as industry concentrations, portfolio profitability, and even average time-to-close.

I once heard a gem of wisdom that rings true: “The best way to make money in commercial lending is not to lose money.”  Implementing a risk management system will dramatically increase your odds of not losing money and being successful in business lending.

Larry Middleman is the President/CEO of CU Business Group, LLC, the largest business services CUSO in the industry, serving more than 580 credit unions in 47 states.  He can be reached at 866-484-2876 or lmiddleman@cubg.org.

Remote Deposit Capture for Business – A Must-Offer

By Larry Middleman, President/CEO of CU Business Group, LLC

Adoption of remote deposit capture (RDC) has come a long way in the past few years. Over that time, the mobile banking revolution has fully taken hold, with smartphones becoming virtual extensions of consumers’ identities. As part of that revolution, mobile RDC (mRDC) became mainstream, and it is now a given that financial institutions offer the service to their members/customers.

Many financial institutions recognize the urgency of this task.  According to Celent’s 2017 report, State of Remote Deposit Capture: The Final Stretch, more than 2,600 U.S. financial institutions went live with mRDC in the last two years.

Isn’t it time for your credit union to offer this critical service as well?

Why Must You Offer RDC?

Saves Time and Money. JPMorgan Chase, in announcing the closing of 5% of its retail branches in 2015, claimed that it realizes a 95% cost savings on every check deposited remotely, versus one processed by a branch teller. Your credit union may not realize such dramatic savings, but it is indisputable that the costs in terms of time, payroll, and branch overhead are significantly reduced when check processing is pushed closer to the end-user.

Your member benefits as well. Time-strapped business owners cannot afford to leave their operations for even a moment to drive to the credit union branch. With RDC, check deposits take far less time and effort, and can be done at the member’s convenience, rather than during “banking hours”. Businesses are free to make deposits more quickly and frequently, improving check clearing times and cash flow.

RDC also benefits the environment by minimizing wasteful trips to the credit union branch, saving gas, and reducing harmful emissions.

Eliminates Geographic Barriers. When competing against much larger banking institutions with branches and ATMs on every corner, electronic services like RDC are ways to even the playing field. Thanks to today’s internet-based technologies, any credit union business member can enjoy the same convenient and speedy account access as with Bank of America. With RDC and other remote banking channels, geography and location are no longer the critical service differentiators they once were.

An Opportunity to Earn Additional Fee Income. Although free mobile check deposit has become common-place among consumers, the additional features that business clients require means that there are still opportunities to charge for services.

Yet high fees may be discouraging commercial clients from adopting feature-rich desktop RDC services. It is important for credit unions to keep the cost factor in mind, particularly as they target down-market into the huge and potentially lucrative SMB sector.

According to Bob Meara, as senior analyst with Celent and the report author, “A low cost and easy to sell mRDC solution appropriate for SMBs is the missing ingredient.”

By offering mRDC, credit unions build stronger, “stickier”, and ultimately more profitable relationships with their business members.

Provides Access to Reams of Member Data. One the most interesting developments in mobile RDC technology over the past few years is its built-in data collection capabilities. For credit unions, the opportunity to mine valuable member data is every bit as important as the payment or check deposit itself.

Transactional data contains a treasure trove of information on your member’s behavior, useful both in managing fraud risk as well as highlighting opportunities to provide better service and address your member’s specific business needs.

What Are the Key Considerations for Rolling Out RDC?

Mobile vs. Scanner: It used to be a simple equation. Mobile device check deposit technology was originally designed strictly for consumers or the simplest, low-transaction business use, as one-at-a-time check scanning is too time-consuming and unwieldy for purposes of depositing a heavy volume of checks.

However, mobile RDC solutions that meet the needs of commercial and small business members much more effectively have recently been introduced. New features allow businesses to submit multiple checks in a single batch, and can even support multiple users working remotely in the field.

Still, mobile RDC is not the right choice for every business. According to industry experts, traditional desktop scanners are still much more effective for high check volumes; say more than 5 or 10 checks at a time. High-volume scanners save business members significant time and a lot of aggravation over snapping one-at-a-time photos on a mobile device.

Risk Management: The risk of fraud is one key reason why many financial institutions have waited to roll out an RDC service offering. The threat is real, but recently reported trends have belied many common perceptions of risk.

According to RemoteDepositCapture.com’s 2016 State of the Industry report, banks and credit unions surveyed suffer a duplicate check loss rate of just 0.0104% on mobile check deposits. The study also stated that 76% of financial institutions surveyed reported no direct mobile RDC losses, and 92% believe that the benefits of mRDC outweigh the risks and costs of the program.

“RDC solutions, when paired with sound risk management policies, actually deliver more data and protections than traditional, paper-based check solutions,” says John Leekley, founder of RemoteDepositCapture.com.

With built-in tools such as geolocation and biometric scanners, smart phones are giving banks and credit unions the ability to identify unusual geographic and psychographic patterns, and prevent fraudulent transactions before they occur. For instance, your credit union’s fraud detection department may recognize a mobile device in California depositing a check from a New York-based bank to the account of a member based in Virginia. You now have the opportunity to contact your member to confirm that the transaction is legitimate. Old-school mail deposits provide no way to spot these types of suspicious transactions until it’s too late.

Access to Tech Support and Staff Training: Having technical support available is imperative to a successful RDC program. Your business members will undoubtedly have questions and problems will arise. It is important to consider up front whether the credit union or the vendor will provide first-line support. Even if the credit union is the first line of defense, it is a big learning curve for staff, so ensure that you have adequate vendor support and training from the get-go.

Such training should go beyond the member contact center and technical areas, however. Credit union branch and business development personnel are the keys to effectively pitching the benefits of RDC to current and prospective business members. Ask yourself these questions before rolling out your RDC service: Who will do the training? Which credit union department will maintain ownership of the service? How does RDC fit into your credit union’s strategic goals and marketing plan?

Gone are the days where RDC is a “nice to have” product. Member expectations have developed to the point where every financial institution must offer at least one, if not several versions of the platform to serve their various target markets. Don’t get left behind in the mobile RDC revolution!

A person notating inspection on a tablet in the foreground. Two people in safety gear visually inspecting and pointing to something out of the image in the background.

Guarding Against Common Appraisal Pitfalls

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.

Deepening Business Relationships Through Payments

By Melissa Giddens, CTP, AAP NCP, SVP, Consulting Business Leader, WesPay Advisors

Most businesses have a need for financial services above and beyond a loan and basic deposit account. Whether the business’ need is online and mobile banking or extends to ACH or wire payment origination services, businesses of all sizes are placing greater importance on the ability to maximize payables and receivables, mitigate the risk of fraud, and leverage information to make cash flow decisions. Credit unions need to have the resources and skills required to help their business members thrive.

Offering payment solutions can help meet the needs of business members, but also generate non-interest income for a credit union. Businesses pay for value perceived, therefore charging a fair and competitive price for payment services can help a credit union serve its field of membership and cover the costs for providing the services. Meeting the needs of businesses from a payments perspective can contribute toward retaining existing relationships, winning new business and creating a ‘stickiness factor’ that lends itself toward long-term, satisfied business members. It’s a win-win situation for a credit union.

Below are a few tips to keep in mind when working with businesses:

  • Lead with a conversation. Make it your mission to learn as much as you can about a business prospect before discussing your product offering. Talk to them about their business and make the focus all about them. Ask them how their current account and service structure is working, what efficiencies would benefit them, if their clients are requesting new payment options, etc. Taking the time to understand what’s working and what needs to be improved upon with their current provider can provide invaluable insight into how your credit union could meet those needs before ever mentioning a single product.
  • Drill into their payments needs. Get the prospect talking. Ask a wealth of questions to understand how they are utilizing payments in their business. How are they managing payroll, vendor payments, employee reimbursements, etc.? Conversely, how are they being paid from their clients? And, keep drilling down. If they receive a healthy number of checks, how are they depositing those checks into their account? Are they going into a branch, using a courier, leveraging remote deposit, etc.? And, are they receiving the information they need to reconcile transactions, manage their cash flow, etc.? What type of reporting do they need? Are they concerned about fraud? The more you understand a business prospect’s payments needs, the better positioned you’ll be when delivering a tailored proposal and ultimately, servicing the relationship.
  • Become a trusted advisor. Relationships with businesses extend beyond the services a credit union provides. Continually look for ways to add value for your member. Share an article on fraud prevention that may be meaningful for them along with a personalized note, send industry updates that pertain to past conversations you’ve had with them, etc. Let them know you’re thinking of them and keeping them in mind as you come across new information or resources. Create an environment where they look to you as their financial resource.
  • Do your homework. Research your prospect to understand their line of business, key company leadership, new initiatives they’re tackling, recent awards they’ve won, etc. and comment on what you’ve learned during meetings. Congratulate them on a new product they’ve launched or an industry award they’ve earned. Demonstrate that you’re prepared and that you’ve done your research. Prospects can tell when a potential provider shows up unprepared, so don’t give them a reason to question whether or not your credit union is the right fit for them.
  • Master the little things. Follow up timely. Do what you say you’re going to do. Send thank you notes or emails. Write down important takeaways you hear during the discussion, such as birthdays, a dream vacation they’re about to take, etc., so you can send them an annual birthday card or ask them how their trip went during your next conversation. Servicing businesses starts with building a relationship with the people you’re interacting with, so going the extra mile to demonstrate you were listening goes a long way toward building trust.

Working with businesses is an exciting opportunity for a credit union, as a business’ needs are continually evolving. Businesses look for a true financial partner to guide them through the changing financial landscape and how new products coming to market, regulatory changes, economic considerations, etc. may impact their organizations. When it comes to payments, selling solutions to businesses provides another opportunity for credit unions to shine in servicing the needs of its communities.

Melissa Giddens is the SVP, Consulting Business Leader for WesPay Advisors, a consultancy helping organizations advance their development and deployment of electronic payments. Prior to joining WesPay Advisors, Melissa worked with businesses for over 21 years to help build optimal structures for managing payables and receivables, mitigating the risk of fraud and maximizing cash flow. In 2016, she won the Frank E. Zima Payments Advocacy Award and has won numerous sales awards throughout her career. Melissa earned her Master of Business Administration from Green Mountain College. She holds the Certified Treasury Professional (CTP), Accredited ACH Professional (AAP) and National Check Professional (NCP) designations. Contact Melissa at mgiddens@wespayadvisors.com or 415-373-1180.

Lending on Real Estate Collateral

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.

If you are a fan of the 1993 Steven Spielberg movie Jurassic Park, you may recall the memorable words of Dr. Ian Malcolm (as played by Jeff Goldblum): “Your scientists were so preoccupied with whether or not they could that they didn’t stop to think if they should.”

So it goes with real estate lending. Huge swings in commercial and multi-family real estate valuations since the financial crisis have rightfully given lenders pause (Fig. 1). Historically, the NCUA has authorized credit unions to lend up to a maximum 80% advance rate on commercial real estate. Recent changes to NCUA’s regulations have removed this prescriptive limit, but it still begs the question of whether you should consider going to 80% loan-to-value (LTV), or even higher, on a particular request.

One question I often receive is: Why is an 80% LTV ratio considered the industry standard for determining adequate collateral coverage? One way to look at this is that 80% represents the breakeven ratio on a typical commercial property, if it goes to foreclosure. You can estimate approximately 10% of property value will be spent on costs associated with the foreclosure process, including legal expense, carrying costs, any needed property repairs, and professional management. Once you factor in the realtor’s commission and any discount the buyer negotiates because it is a foreclosure, total costs may easily reach 20% of property value.

There are a number of factors you should consider when you look at a real estate property. In order to be competitive with other lenders, you often will need to advance 80% to win a deal. Under many circumstances, this will be fine. But you need to consider a few important aspects before approving the loan.

One key factor is the reliability of the appraisal. A real estate appraisal should include several “comparables” or “comps”—nearby properties that are similar in use, condition, and size to the subject property. The more closely these comps resemble your collateral, the greater your confidence will be in its appraised value. One home among a thousand of similar homes, with close, recent comps, will provide you with a high degree of confidence. On the other hand, your level of confidence will be much lower on a property with no local comps or recent nearby sales. After all, an appraisal is simply an educated opinion of value. Some of those opinions are supported better than others. You should take into account the levels of confidence and potential variability in the value in your advance rate.

Similarly, some properties are inherently more marketable. For example, an apartment building, a tilt up concrete warehouse with office space, and many types of retail locations are of general interest and the pools of potential buyers are large. But certain special-use properties don’t offer that same level of general appeal. Such properties include bowling alleys, car washes, gas stations and convenience stores, hotels, water parks, golf courses, and movie theaters. If the property only serves a single best use, you should consider a lower advance rate, because the pool of potential buyers is quite limited. Combined with the fact that, in a foreclosure scenario, the likelihood is high that local market conditions may not support that type of business in that specific location, you are going into a sale at a disadvantage.

There are other factors that may adversely impact the salability of your collateral. Rural locations often have a more limited market, and a lower advance rate is often warranted. The quality of leases and tenants may also impact the value. If the borrower holds a long term lease to a single tenant, the performance of that tenant has an outsized influence on property cash flows, and you may wish to reduce your advance rate. Also, if the current leases are below the market rate the appraiser used, you would want to reduce the advance rate.

Lastly, make sure to consider local economic and business conditions. Some markets, including major metropolitan areas and popular tourist destinations, tend to see much greater volatility in real estate prices than other, more stable areas. If you lend in an area that sees such high fluctuations in property values, consider using a lower standard advance rate than 80%.

Remember that your personal familiarity with your borrower and the local market are major advantages and should factor strongly in your underwriting decisions.

 

Two people shaking hands

Five Keys to Growing Business Deposits – One Credit Union’s Story

By Larry Middleman, President/CEO

Credit unions are looking to build long-term, meaningful relationships with their business members. Leading business lending credit unions realize that a robust, comprehensive deposit program is often the best way to capture the full relationship of larger, more sophisticated operating businesses.

At CU Business Group’s 2016 National Business Services Conference in Reston, Virginia, Mike Blosser, vice president of business services with Interra Credit Union presented a workshop on “Reaching New Levels in Business Deposits”.

Mike Blosser, Interra Credit Union

Mike Blosser, Interra Credit Union

Interra Credit Union ($1 billion, Goshen, IN) has long focused on the agricultural sector.  With 16 branches and 67,000 members, the Credit Union was embarking on a new strategic vision to serve 100,000 members by 2019. In support of this vision, Interra’s senior management has identified growing business core deposits as a key to the cooperative’s long-term success.

Yet management recognized that the Credit Union faced several daunting challenges in achieving this objective. The first was deciding how to pivot focus from its traditional reliance on small business and consumer members, to larger companies that had a need for cash management and other higher-end capabilities.

The Credit Union also bumped up against the limited operational and reporting capabilities of its core system, and needed to bridge critical training gaps within the IT and eServices departments, as well as among front-line staff.

Bob Brenneman, Director of Lending at Park View Federal Credit Union ($168 million, Harrisonburg, VA) a CU Business Group conference attendee, sat in on Interra’s session. The topic was timely for his organization.

“We are figuring out where we want to be in a couple of years from now,” Brenneman said. “We need to do a lot of strategic planning, get some expertise, and hire a few more people to make that next step. We want to offer more services to capture the full business relationship because we have just been so focused on the lending side.”

As Interra’s management dove into their project, they discovered five keys to creating a successful business deposits program, including:

1. Implement the right technology

At the time, Interra was in the process of implementing Q2, an omni-channel digital banking solution. The Credit Union specifically chose Q2 because it was built on a business banking platform, a rarity in an industry that often takes a “consumer-first” approach. This gave Interra executives the confidence that Q2 would be able to meet the needs of its sophisticated commercial clients.

The Q2 platform also includes a built-in business online banking solution, eliminating the need to integrate with yet another vendor.

2. Ensure the right product mix

From remote deposit capture to sweep accounts, from positive pay to business online banking, Interra was intent on offering commercial clients a full suite of electronic services to address every current need and anticipate future growth.

Prior to 2014, the Credit Union’s business product mix was extremely limited, including just one checking account and a few services such as a debit card, a business credit card, and online banking services built on the consumer platform.

Fast forward to today, and Interra now offers four distinct analysis checking accounts to address the unique needs of a variety of businesses, a true business debit card, and two types of credit cards (with EMV). The Credit Union also upgraded to a robust business online banking platform, supports online account opening, and offers a full treasury management suite including ACH, remote (and mobile) deposit capture, online wire transfers, positive pay, and multiple user capabilities, all available across a range of devices.

3. Staff for success

In his talk, Blosser stressed the importance of ensuring the team is ready and energized to serve the complex commercial market. Since 2014, Interra has aggressively grown the business services department, which includes a business development manager, a treasury management officer, a business services specialist, two business lending specialists, and a credit analyst. The commercial lending team doubled in size from two to four loan officers.

The Credit Union incentivizes its lenders to keep them engaged and focused on growing the portfolio. However, rewards are based on ongoing portfolio performance and loan quality, instead of sales goals, ensuring that individual and Credit Union motives are fully aligned.

4. Invest in comprehensive training

In the past, the Credit Union’s eServices department handled all new electronic banking setups for business members, as it does for consumer members. Yet without a background in business services, eServices staff didn’t have a strong understanding of business member needs.

Recognizing that business development officers are in the best position to serve business members and capitalize on opportunities to grow relationships, management trained them to set up business members on online banking, remote deposit services, and other treasury management and electronic services. The results: growth in eServices adoption and improving member satisfaction.

Interra also offers training in business products to all employees, allowing the entire team to engage in positive and meaningful conversations with business members with less anxiety.

5. Create positive brand awareness

Once the systems and infrastructure are in place, an expanded product mix is deployed, and key sales and service personnel are trained, it’s time to get the word out. Interra focuses on staying involved in the community, building on the brand awareness developed through its consumer and agricultural business lines, and using easy methods of promotion including posting “Financed by Interra” signage at commercial construction project sites.

 

Interra’s results have been impressive. Today the credit union has 78,000 members.  Business checking and savings accounts have grown by $37 million, bringing total business deposits (including money market accounts and certificates) to a total of $250 million.

Remote deposit capture is now being used at 78 business locations, processing a total of $7 million per month. 130 businesses are using ACH for processing payroll, payment collections, or making vendor payments. Credit card swipes are up by over 500 transactions per month, and over 300 business members are now using the new business online banking platform. Perhaps most impressively, Interra has opened 1,100 new business account relationships since going live with the new strategy.

Park View’s Brenneman found inspiration from Interra’s roadmap, citing Interra’s focus on deep-dive portfolio analysis, and its decision to offer commercial clients a comprehensive business online banking product.

“At our Credit Union, we are at a point where we’ve been all working hard, and we need to make a step to increase our growth trajectory,” Brenneman says. “[This session] provided me with some strategies we can work on to offer a full-service program to our business members.”

Farm equipment cutting down wheat

Securing Your Collateral – Establishing and Perfecting Liens

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.

The Great Recession taught many business lenders the importance of securing collateral. Although credit union business loan delinquencies have dropped back to historically normal levels of around 1%, from a peak of over 4% at the height of the financial crisis, securing your collateral position is still a cornerstone of any successful business lending program.

Credit Union delinquencies and charge-offs as a percent of outstandings.

Credit union MBL delinquencies peaked at over 4% in 2010 and 2011.

The taking of collateral on any loan requires two steps.  The first is establishing the lien, which is done by a security instrument.  For real estate, that is a deed of trust or mortgage, for cash it is an assignment of deposit account, and for anything else it is a security agreement.

The second step is “perfecting” your lien. Once your right to the collateral is established, you need to let the world know it is yours, which is done by a process known as “perfection”.  In real estate, perfection is attained through the filing of the deed of trust.  With cash, perfection is achieved by holding the cash.  For titled vehicles, perfection is achieved by registering your lien with your state’s motor vehicle division or department of licensing.  For everything else, you must use a UCC filing to perfect your interest in the collateral.

UCC filings are subject to the same rules of priority, essentially, as deeds of trust.  The first to file on a class of assets has the first right to the collateral.  Each UCC filing is date and time stamped, and that determines your position in line.

Many items you may want to take as collateral do not have titles or deeds.  Most specialized equipment, such as construction equipment, agricultural equipment, manufacturing machinery, and restaurant equipment typically don’t have titles.  Other assets such as accounts receivable, inventory, intellectual property, taxi medallions, patents, trademarks, and copyrights are also perfected by UCC filings.

There are a few peculiarities of this system that make the process of perfection challenging.  One is how the collateral is described in the filing.  For example, if you have a company that rents equipment out to contractors, and also sells equipment to the public, when you look at a specific piece of equipment it may be hard to tell if it is inventory or equipment.  When you take inventory as collateral, you also need to take “proceeds” of your collateral, which would typically be cash or accounts receivable.  Fortunately many of these items are covered well by loan documentation systems.

However, to use a system effectively, there are a few key tips.  One is to use as general of a description as possible. For example, you should describe the collateral on an operating line of credit as “all business assets,” rather than “accounts, inventory, and equipment.”  This will automatically pick up assets such as sale proceeds and chattel paper that should be part and parcel of your collateral, but won’t be counted if you use the shorter, more specific description.  We also recommend that you use both a specific and a general description of your collateral, for example: “All equipment, including, but not limited to, a 2010 Caterpillar 6D Tractor, serial number CAT###.”  This will also cover you in case of a clerical error in the description.  If the specific equipment is actually a 2009 rather than 2010 Cat, or if the serial number is wrong, you still have perfected the lien under the “All Equipment” part of the description.

It is also worth mentioning a process called a “Purchase Money Security Interest” (PMSI).  This allows the security holder to be in first position on a specific piece of equipment, even if another lender has filed it under “all equipment” ahead of you.  Similarly, your collateral analysis will be impacted if you have an all equipment filing and another lender finances a specific piece of equipment under a PMSI.  In that case, you should remove the value of the equipment from your analysis of collateral value because you are in a second position on that particular asset.

The description of your collateral, the method of perfection, and the documentation of your rights all form the basis of the collateral analysis on a commercial loan.  It is generally a straightforward process, but as with much in commercial lending, the devil is in the details.