ANAHEIM, Calif.–The complexity, risks and resulting potential costs to credit unions of commercial lending were readily apparent during a discussion here, with a warning issued as many CUs push LTVs even higher.
As credit unions have grown larger they have increasingly pushed into the commercial lending space, moving far beyond small loans for mom and pop businesses or commercial properties. In the process CUs have seen portfolios grow—but many have also experienced some painful and expensive lessons on loans gone bad when it came to selling or even repossessing collateral.
A problem common to many of those losing scenarios: overly optimistic appraisals and plans that didn’t take into account a host of related expenses during and following repossession, as was made clear to credit unions attending the CUNA Lending Council’s annual conference here.
Jim Devine, CEO of Hipereon in Kirkland, Wash., shared a sobering checklist of issues credit unions must consider when it comes to collateral management, interspersing his remarks with anecdotes about CU loans gone bad that would have been funny were they not such substantial losses.
“When does collateral become most important to a lender?” asked Devine several times during his remarks. “When it has to convert to be the primary source of repayment.”
Devine said his experience is it is “very, very difficult” to get whole on any loan with 80% loan-to-value, and that in some types of commercial lending getting whole on any loan above 50% LTV is “next to impossible.”
“Don’t get caught up in the belief that if you have the dirt you won’t get hurt. It will jump up and bite you in the throat,” he told the meeting, sharing stories of lenders who have been bitten.
Critical Collateral Management Concerns
The vast majority of credit union member business loans are in commercial real estate where the appraised value and the actual value are often two different things, he said. That gulf is even wider in other types of commercial loans, he said, sharing the story of one CU that had to go to a forest on a mountain to repossess a number of pieces of logging equipment that left the credit union parking it on the lot at its own main office, where it had to deal with security and maintenance costs, and then got just 17% of the appraised value when it finally sold it.
“We like to call collateral CRAP: Can’t Render a Payment,” said Devine. “In its physical form it does you no good. Until I sell it, I don’t have the ability to fix this credit situation. You have to have a conversion plan. Where is it? What’s it worth? What kind of collateral? Do we have the right to go get it? How do we take care of it while we execute the sales plan? Do we even have a sales plan?”
LTV Standards
Devine noted LTV standards at most credit unions that make commercial loans have been liberalized since 2017, with many policies going above 80%, often way above 80%. “Those realities scare me to death when I see them played out,” he said. “Think about value in the context of having to use it as the primary form of repayment. It’s a much different thought process than thinking about it as collateral.”
Real Property Types
Credit unions often make loans on both owner-occupied and non-owner occupied businesses, pointed out Devine.
“Most businesses owners want to own the property as an individual and then rent it back to themselves,” he said, due to the tax advantages. Those owner-occupiers also often pay above-market rent for the same reason. “When you have to take back an owner-occupied property, it’s not generating any revenue of consequence and may even be vacant. So have a sense of that.”
Commercial Special Purpose Facilities
With special purpose facilities, there is a high likelihood of environmental concerns, he cautioned, and once a CU takes it back it can find itself on the hook for an expensive clean up.
Appraisers
“Finding appraisers can be a challenge,” said Devine. “The number of appraisers in the game today in contrast to before the recession is down 30% to 40% due to the exposure that they had. There is an acute shortage of talent in the appraisal industry.” Finding properly licensed appraisers only adds to the challenge, he added.
Moreover, USPAP standards require appraisals be arm’s length evaluations, he reminded, noting all lenders are supposed to maintain a list of qualified appraisers we have vetted. Then, once an appraisal is provided, someone at the credit union must be responsible for reviewing and critiquing it, he said.
Property Functional Condition
Devine said the credit union lender must constantly monitor the kind of shape a property that is collateral is in. The CU must check everything, including plumbing, HVAC, elevators, escalators and more. “It all has to function or the property is going to be challenging to sell or re-rent,” he said.
Devine shared the story of one credit union that had made a commercial loan on a property to which the previous owner had made unique changes that required almost $500,000 to renovate in order to get it to a condition that would make it rentable again. “And that was in a market with 27% vacancy rate,” he said. In the end the CU took a $2 million write-off.
“We better understand market conditions, because those realities are going to play out when we get the collateral back,” said Devine. “When you take property back you have to manage it, and that takes time and money to maintain it. It’s an ongoing requirement and the question at the end of the day is if you take it back are you going to do that, or hire it out? It’s not cheap. If you have to find new tenants, how you going to do that? Hire brokers? They are expensive. You may have to provide free rent or provide move-in cost coverage just to attract someone to come. Tenant replacement costs are more than just a brokerage fee. There could be a number of additional cost elements to consider.”
Property Types
When it comes to all the various property types, Devine covered issues related to each:
- Business equipment, furniture and fixtures: “You can find warehouses full of furniture and fixtures that sell by the pound.”
- Business accounts receivables: “Now you have to collect, and how do you do that? The likelihood you will have recourse is really suspect.”
- Business inventory: “You could have integrity, shrinkage, spoilage, technology issues and so many elements of cost related to caring for inventory.”
He related that one Minnesota CU with which he has worked recently has taken possession of 120 dairy cows that every day it now must milk, feed, provide medical attention and deal with waste.
Devine said he would not make a loan with LTV above 50% on those types of loans with inventory.
Perfecting Lien Rights
Another issue to deal with is perfecting the lien rights, which if not done right will mean the credit union can’t even get to the collateral. That means ongoing updates and contact with county recorders and land use records, dealing with UCC filings and various secretaries of state. There also must be credit file security agreements in place.
“We have to have documents in the file that initiate our ability to get the collateral. It’s all got to be in sync,” he said. “If we somehow have a flaw and don’t have the legal right to possess, now we have a whole new challenge: the collateral we thought we had we don’t have. So who is making sure this is all being done correctly?”
When it comes to ranking lien rights, Devine added, “Who has first position? Other lien holders? We have to make sure we don’t put other lien-holders in harm’s way just because we are trying to take care of ourselves. That can come back and haunt you like you won’t believe.”
Commercial Reasonableness Standards
Prior to making any loan on non-fixed property, a CU must ask itself what it will do with it should it repossess, as there is a responsibility to keep it safe and secure. “Where do we actually park the collateral? Storing some stuff isn’t cheap. And it has to be secure, which has other cost elements. It might need to be physically maintained. There might be property taxes and property insurance that needs to be paid. Are you aware of those costs and have you considered those costs relative to getting your money back? Are there any clean-up and repair costs?”
Finding a Buyer
At the end of the day, said Devine, the conversion issue is where it always settles. “We have to have a buyer and what price are they willing to pay? How will purchase price be structured? Will it need to be financed, and are you going to finance it, and there are issues associated with that that are challenging?”
Transaction Costs
Transaction costs must be factored in, including brokerage fees, auction fees and other percentages of the property to have someone facilitate connection to a buyer, noted Devine.
Lender Could Use a Glass of Wine
Devine shared the story of a credit union that made an $800,000 loan on a piece of wine-making equipment appraised at $1.2 million. When that loan went south, the credit union discovered it was housed inside a building on which the same borrower was $80,000 in arrears on rent. To get access, the CU had to pay the back rent. When it finally got inside the building it discovered its collateral had been set in 30 inches of concrete. That required cutting it from the floor, which led to the further discovery that there were no doors or windows big enough to move the equipment through. To get the collateral, the credit union had to pay to remove (and then replace) the building’s roof using a crane. To get the equipment to a wine equipment auction, the CU had to rent a large truck that required it could only be moved at night because it required three lanes of a freeway, which meant also paying for Highway Patrol escort. In the end, the equipment appraised at $1.2 million sold for $79,000, and due to all the other costs (the landlord also filed suit), the CU eventually lost $2 million on the $800,000 loan (which doesn’t count the time involved).
Much of that could have been avoided, reminded Devine, had the credit union done more due-diligence.
Final Reminder
“What are we? Cash flow lenders,” said Devine. “If the cash don’t flow, the loan don’t go.”
To make a commercial loan that pays off, Devine said the CU must do the initial underwriting correctly, must ensure cash flow can cover the payments, and it must be confident in the real, tangible value of the collateral for the life of the loan.
Many basic assumptions around the value of collateral, reminded Devine, are often overly optimistic, while CUs underestimate all the costs involved in obtaining the collateral and then selling it.