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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.

 

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.

Lending to Operating Companies vs. Investment Real Estate Graphic

Lines of Credit – Lending to Operating Companies vs. Investment Real Estate

Small business is growing once again in the U.S. Following the 2008-09 recession, the number of businesses in the U.S. with fewer than 500 employees fell precipitously. By 2013, small business had once again rebounded to 2009 levels.

This spells opportunity for credit unions. Credit unions have long gravitated toward investment real estate as a relatively simple way to do business lending, as the source of repayment on these loans is easy to understand and is generated primarily from rental income. However, lending to operational businesses can add diversity to your loan portfolio. These businesses, such as tire stores, restaurants, or clothing retailers, generate their income by selling goods and services or adding value to the manufacturing process chain.

Census bureau small business figures

By 2013, small business had once again rebounded to 2009 levels

The risks related to investor property income flows generally correlate closely with longer term trends in the local real estate market. Are vacancies going up? Are local population demographics changing? Is population on a rising or declining trend?

With an operating company, the long-term business risks are the same, but there are unique short-term risks as well, such as:

  • Can the owners hire adequate staff?
  • Can they sell their product at a profitable margin?
  • Are costs of labor and raw materials rising?
  • Are new competitors moving into the market?

The collateral risks between investment real estate and operating entities differ as well. For example, a line of credit secured by inventory and accounts receivable can be fully secured one month, and virtually unsecured the following month. The marketability of inventory is highly dependent on its current state in the process and may become stale or obsolete in a short period of time. Lenders need to liquidate receivables quickly; if you wait too long, they may have already been collected and spent by the borrower. Specialized equipment also has its own challenges as it has a limited market and may deteriorate and depreciate quickly.

Because of these differences, each type of lending demands a different approach toward credit analysis. Fundamentally, all loans rely on the good character of the business owners. The credit report and personal financial statement set the tone for the relationship. But a few additional items should be considered:

  • Debt service coverage: When analyzing an investment property non-owner occupied real estate loan, the focus of the analysis should be on the debt service coverage ratio, which reflects your best chance of being repaid on the loan. As long as the collateral is in good shape and market conditions are favorable, repayment is likely. Borrower leverage is not as important, as long as you have strong collateral coverage. Working capital is almost immaterial, and most of these entities can function just fine with a low-balance checking account.
  • Working capital: For owner-occupied real estate and operating company loans, the analysis of the loan, and your risk rating, should be based on a complete understanding of the operating company as your primary source of repayment.

Similarly, the analysis of an operating company line of credit facility should focus mainly on working capital. The purpose of such lines is to help support the company’s working capital needs, and the primary source of repayment will be the turnover of operational assets.

Stick to Your Knitting

For lenders, the bottom line is that the type of borrower and the type of credit facility should drive the analysis and the credit decision. As an organization, you may have expertise in certain types of loans or industries. If that is the case, you should minimize your exposure to those types of borrowers where you have little expertise, or consider outsourcing that analysis to a service provider with experience in that particular field.

Lines of Credit Evaluation

Lines of Credit – Line Management and Evaluation

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 MBLs tend to be more varied and wider in scope. The credit union industry is expanding further into relationship lending with business members. The next logical step is to gain capabilities in lines of credit, as these are often the lifeblood of a business’ cash flow. This article is one in a series to help credit unions more clearly understand some of the unique risks.

Lines of credit are an important product to offer your business members. However, they tend to be complex, and if they are not managed properly, your member can get into hot water.

One of the biggest questions surrounding business lines of credit is in determining how large of a line of credit should be offered to the member. The correct answer to that question is dependent on the member’s unique circumstances in regard to their sales and credit practices.

Consider a business that offers 30 day net terms to its customers, and sells 100% on account. In this scenario, monthly sales will equal the amount of accounts created each month. If the business’ customers pay an average of 30 days from invoice, accounts receivable will remain consistently at a 30 days of sales level. For example, if the business has sales of $1.2 million each year, and it collects all accounts at an average of 30 days, then accounts receivables will remain at an average of $100,000. But the average collection time for most businesses is about 45 days, and as the lender you should not advance much more than 70% against receivables. So in a typical business that sells all on account, a line of no more than 10% of gross sales is recommended (Ex. 1).

Ex. 1: 100% of Sales Account

  • $1,200,000 sales * (45 days/360 days) * 70% advance ratio = $105,000 line of creditTotal Non-Real Estate Secured MBLs

Now consider a retail business, in which half of sales are paid for in cash or credit card payments, and half is paid on account. How large of a line would this business need? The short answer is: half as much. They are now selling $50,000 per month on account, and receivables are running at an average of $75,000. At an advance rate of 70%, an appropriate line would be no more than 10% of annual receivables, or a maximum of $60,000 (Ex. 2).

Ex. 2: 50% on account/50% cash:

  • $1,200,000 sales * 50% on account * (45 days/360 days) * 70% advance ratio = $52,500 line of credit

Seasonality is another key decision factor. I once had a client in Alaska that worked only during the summer months, just three months out of the year. In his case, the normal receivables level was one third of his sales! Businesses with significant seasonal fluctuations in sales have a much greater need for a line of credit than those with little or no seasonality. The advantage to you as the lender in this scenario is that at the end of the season, sales go to zero, expenses go to zero, all accounts are collected, and the line is paid off in full.

Now, consider a business with no seasonality at all. How would your member pay off the line of credit? The aggregate level of receivables never goes down (a source of cash) nor does it ever increase (a use of cash). In a non-seasonal business, the only way to experience large swings in line of credit usage is with big swings in sales! So, while it is useful to have a cleanup or resting requirement in your loan covenants, you can create automatic covenant violations if the business does not experience large seasonal variations. A better course is to establish a line to fund only the seasonal variation in the accounts. The permanent, fixed portion of those accounts should be funded with capital, i.e. a working capital loan or equity in the business.

Lines of credit are complex products that require extensive due diligence up front, and regular monitoring going forward. Don’t make the mistake of providing your member with the wrong product for their needs, or “setting and forgetting” the line of credit after closing. This is a disservice to your member, and one that may result in many headaches down the road.

About CU Business Group
Established in 2002, CU Business Group, LLC, provides a wide array of business lending, deposit, and consulting services to credit unions nationwide. Based in Portland, Oregon, with offices in the West, Southwest and Eastern U.S., CU Business Group has a staff of 40 professionals and serves more than 500 credit unions in 46 states.

Model house with cash spread out in front of it

Lines of Credit – 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 MBLs tend to be more varied and wider in scope. The credit union industry is expanding further into relationship lending with business members. The next logical step is to gain capabilities in lines of credit, as these are often the lifeblood of a business’ cash flow. This article is one in a series to help credit unions more clearly understand some of the unique risks.

Lines of credit are an important product to offer your business members. However, they tend to be complex, and if they are not managed properly, your member can get into hot water.

For fully revolving lines of credit, collateral will play a large part in your analysis. For example, if the member provides real estate equity adequate to fully secure the loan, the collateral analysis is pretty straightforward. You already know how to calculate a cumulative loan to value, and you can apply that as in any other business loan. This is a simple approach and allows a clear understanding of the collateral. If you are considering taking business assets as collateral for the line, your analysis will be a bit more complex. Many lenders just use book values on business assets and adjust for appropriate advance rates. Take for example a member with a $100,000 line of credit with an outstanding balance of $45,000. The borrower provides you with an account receivable aging schedule showing $75,000 in accounts receivable on their balance sheet. In most cases, the advance rate on receivables should not exceed 70%, and in this example the advance rate is 60% ($45,000/$75,000), so it would be conforming (Ex. 1).

Ex. 1: Accounts receivable held as collateral:

  • $45,000 balance / $75,000 A/Rs = 60% advance rateAverage Loan Size Total Non-Real Estate Secured MBLs

Now let’s say this same member has advanced an additional $25,000 on the line. This time, the member has pledged inventory along with accounts receivable as collateral. How much inventory would be required to cover the higher balance? Inventory is considered to be a much riskier asset than accounts receivable, as there is no guarantee that the business will be able to complete production and sell its wares. A typical recommended advance rate on inventory is 30%. So in this scenario, a collateral balance of $58,334 in inventory would be required (Ex. 2).

Ex. 2: Inventory and A/Rs held as collateral:

  • ($45,000 + $25,000) = $70,000 balance outstanding on line
  • ($75,000 x 70% advance rate) = $52,500 covered by A/Rs
  • $70,000 – $52,500 = $17,500 to be covered by Inventory
  • $17,500 / 30% advance rate = $58,334 Inventory required

If the line were fully advanced at $100,000, how much would need to be outstanding in your member’s purchase orders for you to be fully covered? Trick question! No advances should ever be allowed on purchase orders. The reason is that a purchase order, unlike an accounts receivable, does not represent a completed sale (i.e. completed delivery of a good or service with a contracted promise to pay).

For example, your member stops into the credit union and exclaims, “Wow! I have purchase orders for 200 of my finest widgets, and I only need to borrow $10,000 to pay for the materials and labor to produce them.” That is indeed exciting news for your member, but he will be better served if the funds are provided by investor capital or from some other source such as a home equity loan or a startup loan from the Small Business Administration. This financing should not be provided by your credit union, purely based on timing. Accounts receivables are due for payment in 30 days and represent a real source of repayment. Inventory represents cash that is due to be paid further out, which requires more steps before it can become a source of repayment. First they need to be sold, then packaged and shipped, then billed, and then, finally, collected. With a purchase order, the source of repayment is even further removed, and there is a great deal more uncertainty in converting that to repayment on your line of credit.

Verified and inspected equipment may represent some additional strength, and may offer additional collateral in your analysis. However, it is often used simply to provide an additional level of comfort or abundance of caution, you would typically not lend against it. For several reasons it is often quite difficult to ascertain accurate equipment values. One is that many types of equipment are specialized and for a specific use, and it may be difficult to obtain a qualified, independent appraisal of the true value. Secondly, equipment financing tends to be piecemeal, and a business with more than three pieces of equipment probably has a loan on one of them. In order to know what collateral is available, you would need to know what specific equipment already has a lien, what value is shown for it on the company’s statements, and what accumulated depreciation is shown for that piece. With this information in hand, you can then calculate the value of the collateral available to secure your loan. If available, published book values are a better gauge than relying on your client’s assessment of value.

As one of the “5 Cs of Credit”, collateral analysis is an important piece of the business lending decision, and the various types of collateral should be evaluated differently. You may have all the confidence that your member will repay the loan as agreed, but if you use the proceeds to finance the acquisition of an asset, you should take that asset as collateral. If anything goes wrong, you will be glad you did.

About CU Business Group
Established in 2002, CU Business Group, LLC, provides a wide array of business lending, deposit, and consulting services to credit unions nationwide. Based in Portland, Oregon, with offices in the West, Southwest and Eastern U.S., CU Business Group has a staff of 40 professionals and serves more than 500 credit unions in 46 states.