Dimension 5 - CRC US Body of Knowledge PDF

DIMENSION 5 - 2 NOTES: DIMENSION 5: EVALUATE COLLATERAL VALUES AND CONDUCT PERIODIC INSPECTIONS OF COLLATERAL PURPOSE OF DIMENSION 5 The purpose of Dimension 5 is to review skills required to evaluate collateral. Key topics in this Dimension include: The Concepts of Quality and Verifiability of Collateral. Securities and Investments as Collateral. Accounts and Notes Receivable as Collateral. Inventory as Collateral. Plant and Equipment as Collateral. Intangible Assets as Collateral. Understanding the Real Estate Appraisal. ADDITIONAL SKILL-BUILDING RESOURCES The material in the Body of Knowledge provides an overview of knowledge related to topics covered by the Credit Risk Certification exam. Mastery of topics reviewed here is essential preparation for the exam, but no amount of reading and study can substitute for lending skills that must be acquired through formal classroom and on-the-job training. In addition to reviewing the Body of Knowledge, consider taking the following RMA courses to support your Dimension 5 skillbuilding: CRC US Body of Knowledge Asset-Based Lending for Non-Asset-Based Lenders Understanding and Interpreting Real Estate Appraisals DIMENSION 5 - 3 THE CONCEPTS OF QUALITY AND VERIFIABILITY OF COLLATERAL NOTES: Evaluating collateral begins with an understanding of the borrower’s asset quality and valuation. These topics are included in the Dimension 3 study guide materials, which you should read prior to reading this discussion of collateral considerations. Quality. How good is the collateral? What is its value, and how readily can we expect to realize that value in the event of liquidation? Verifiability. How accurate is our assessment? Does the collateral conform to representations made by the borrower regarding type, quantity, and quality? Do we have the means to test the accuracy of the borrower’s representations for the type of collateral under consideration? The primary types of property we will discuss in this section are: Securities and investments. Accounts and notes receivable. Inventory Plant and equipment. Intangibles For additional information on evaluating quality of collateral, see also Dimension 3 for discussion of evaluating cash and cash equivalents. For information about securing and perfecting interests in collateral, see Dimension 6, which also includes information about verifying insurance coverage of collateral. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral In this section, we will review specific considerations for evaluating assets commonly taken as collateral. Collateral concerns can be divided into two comprehensive areas: DIMENSION 5 - 4 NOTES: SECURITIES AND INVESTMENTS AS COLLATERAL Note: Comments in this discussion pertain only to non-purpose loans; i.e., commercial loans for purposes other than to purchase or carry margin stock, and for which the marketable securities are pledged or assigned as collateral. Purpose loans—loans made to finance the purchase of margin stock—are subject to Regulation U and are outside the scope of this discussion. Marketable securities include stocks, bonds (both government and corporate), bankers acceptances, commercial paper and mutual funds. Investments may include stock in privately held corporations, or ownership interests in limited liability companies, partnerships, etc. To qualify both marketable securities and investments entails analyzing two key considerations: value and liquidity. VALUE CRC US Body of Knowledge The term marketable implies publicly traded issues, and indeed shares or securities issues by private companies generally have very limited collateral value. However, you may be asked to consider the pledge or assignment of interests in private companies, either because your borrower has an investment in an affiliated company, or because an individual has proposed providing his or her personal interest in a private company as collateral for a commercial loan. Consider the following issues pertaining to publicly issued and private securities. DIMENSION 5 - 5 PUBLICLY TRADED SECURITIES Marketable securities that are publicly traded have easily determined values but are generally subject to price volatility. NOTES: Although market and other influences mean the values of publicly traded securities are volatile, considerable information is often available to help assess a likely range of near- and intermediate-term value. This includes: –– Market capitalization. If an issue has less than two billion dollars in capitalization, it is considered a small stock issue and value may be unusually volatile from the disproportionate impact of transactions initiated by institutional investors. –– Analysts’ research reports, which may be available for mutual funds in addition to individual securities issues. –– Public debt or commercial paper rating. –– Industry trends, often included in analyst report comments, or the product of your own research. Keep in mind that analysts and rating agencies’ assessments are not guarantees of future value. Most marketable securities are subject to event risk, including a wide range of potential events and circumstances that can interfere with even expert assessment of future asset value. Examples include market response to world events, economic sector performance announcements, individual company earnings announcements, etc. The borrower’s portfolio management strategies can aid in the preservation of collateral value. Identify the individual responsible for maintaining the marketable security portfolio and discuss the following issues: –– What is the composition of the portfolio? Is it a well-balanced mix of securities, including equities and fixed income securities? Are maturities of income securities diverse? –– Are there concentrations within the portfolio? Concentration analysis should include both issuer and industry. –– Is the portfolio actively managed, and if so, by whom? What are the credentials of the individual managing the portfolio? –– What is the portfolio’s historical profitability trend? Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral –– Market price trends, including 52-week high and low, to evaluate volatility. DIMENSION 5 - 6 NOTES: NON-PUBLICLY TRADED SECURITIES AND OWNERSHIP INTERESTS The value of non-public securities can be difficult to assess without a diverse and observable market to establish trading prices. In general, you should discount 100% the collateral value of private securities or ownership interests unless valuation has been verified through acceptable analysis. Acceptable analysis may include, in the order of most to least credible, professional business valuation, earnings or book value multiple based on market conditions, or book value net of intangibles. If a value is verified, discount the value by 30% as a margin for error before considering as a source of secondary repayment. The best way to determine the value of securities in a private firm is to obtain a valuation analysis created by a qualified valuation expert. Respected valuation credentials include: –– Certified Business Appraiser from The Institute of Business Appraisers. –– Accredited Senior Appraiser from the American Society of Appraisers. –– Certified Valuation Analyst, from the National Association of Certified Valuation Analysts. –– Accredited in Business Valuation, awarded to CPAs by the American Institute of Certified Public Accountants. –– Chartered Financial Analyst from the Association for Investment Management and Research. Private company valuations are usually performed using a discounted cash flow model. These models require assumptions regarding: CRC US Body of Knowledge –– Estimated future cash flows. –– Cost of capital and appropriate discount rate, adjusted to reflect illiquidity of the company shares. DIMENSION 5 - 7 A private company may offer shares of a related company or a subsidiary as collateral for a loan. In addition to the valuation issues discussed prior, there is likely to be material correlation between the financial performances of the two companies. A deteriorating condition of the parent company (and your borrower) may have a spill-over effect on the affiliated company whose shares are your collateral. Consider also that a business unit’s stock securing a parent’s debt represents only the residual value of that business unit after any direct claims against the unit’s assets. If the business unit has liabilities, there may be little residual value of the business unit’s assets to provide the secondary repayment source for the parent company’s loan. However, there can be circumstances where one or more valuable assets—such as a license or a patent—have been transferred to a business unit that otherwise has no business activity and is protected from liabilities. In that case, the parent’s pledge of its business unit’s stock may have material value as collateral for the parent’s debt. For additional considerations concerning the possible collateral value of intellectual property, see the discussion of intangible assets as collateral later in this Dimension. NOTES: Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Assuming you have a valuation, and that valuation credentials are acceptable, keep in mind that there is still a significant difference between valuation-based share value and collateral value. In most cases the illiquidity discount does not fully reflect the practical limitations to where the bank might market shares of a private company. If there is no practical market for sale of shares of a private company, there is no effective value as collateral for a commercial loan. DIMENSION 5 - 8 NOTES: LIQUIDITY Securities provided as collateral for commercial loans should be easily transferable to the bank and readily convertible by the bank into cash should the bank need to realize proceeds from the collateral. Liquidity considerations include: Are the securities widely traded? Securities that are thinly traded may be difficult to sell at short notice. –– Securities should be listed on a national exchange, such as the New York, American, or NASDAC exchanges. –– Mutual funds should be quoted in public indexes, such as Barron’s or the Wall Street Journal –– Rated issues should have minimum ratings as specified by your bank’s own guidelines, to ensure there is a value range that ensures continued, active trading in the issue. –– Securities should be trading at minimum values, generally at least $10 per share. If a private issue, are the securities certificated? To be available as collateral, the securities must be evidenced in a format that lends itself to perfecting a security interest. See Dimension 6 for a discussion of related perfection issues. CRC US Body of Knowledge Do the securities have legal or regulatory restrictions to sale? These include: –– Restricted stock, securities acquired directly or indirectly from an issuing company or from an affiliate of the issuer, not involving a public offering. These securities may also be called investment stock, letter stock, or private placement stock. Restricted stock may not be sold by anyone (including the bank or borrower in a foreclosure) until required holding periods have elapsed. Usually a restricted stock certificate bears a restrictive legend on its face. The Securities Act of 1933 provides that securities being sold for specified persons must be registered with the SEC before an offering can be made unless the transaction or security is exempt. You are likely to see restricted securities in the following situations: a. Restricted stock (i.e., stock acquired directly from an issuer in a transaction). b. A chain of transactions without any public offering, for example: DIMENSION 5 - 9 1. Individuals who obtained their stock as a result of the acquisition of their company by another company. NOTES: 2. Officers, directors, and employees who obtained stock in an unregistered options program. 4. Sales by charities, schools, hospitals, churches, etc., which may have received the stock they are selling by donations from any of the above individuals. These institutions often receive gifts of this type for tax purposes. The SEC has adopted Rule 144, which is a guide as to when and how a seller may claim an exemption from registration, provided all the elements of the rule are present. You cannot assume that the prohibition against public resale disappears simply because the stock has been held for a long period of time. Although restricted stock often bears a restrictive legend or stamp upon it to indicate it is not freely tradable, absence of a legend or stamp is not conclusive evidence the stock is not restricted. A good policy when considering accepting any stock offered as collateral for a business loan, whether offered by a business entity or an individual, is to specifically ask if there are any legal restrictions on sale of the stock. Control stock, stock owned by a control person or affiliate of an issuer that directly or indirectly controls or is under common control with the issuer. Control stock can only be sold quarterly after the control person or affiliate has made required public disclosures, and is limited by a formula established by the Securities and Exchange Commission. A lender in possession of control stock as collateral is governed by these regulations. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral 3. Individuals who participated in the founding of a corporation that has subsequently gone public. Note: Accountants, attorneys or other professionals rendering services to such private corporation before they go public often accept stock for services rendered. These are restricted securities since they have been acquired in a nonpublic transaction. DIMENSION 5 - 10 NOTES: By this definition any major stockholder, officer, or director (or member of his/her family) is an affiliate since they either control it or are controlled by it or are under common control with it. Even if an officer or director’s holdings are minimal, that individual must comply with Rule 144. The restriction on the sale by an affiliate is a prohibition against the individual or his/her immediate family from selling the security that he/she holds. If you have stock pledged by an officer or director, there is likely to be a Rule 144 compliance issue that will prevent the bank from selling the stock to liquidate its collateral. It is more difficult to identify actual control of the corporation. Any individual who presents a large block of stock, or whom you know has substantial holdings in a company, should be questioned to determine the total number of shares held or in which he /she has a beneficial interest. Other considerations, such as the total float, total number of round lots outstanding, relationship of the seller to and how the stock was acquired from the issuer, etc., may govern whether shares are considered to be control stock. If stock is being pledged to support a commercial loan, it is vital to understand whether there are any control stock issues that will prevent the bank from liquidating its collateral. You should consult your bank’s legal counsel if you have any question about how or whether it is necessary to investigate control stock questions. Sale or transfer restrictions that preserve the entity’s tax status. For example, limited liability companies and partnerships generally have limitations on the sale or transfer of their ownership interests, often to preserve a tax distinction from a corporation. Are the securities required for transactional purposes? These securities may have limited practical value as collateral. Consider: CRC US Body of Knowledge –– What is the purpose of the securities portfolio? If securities pledged or assigned as collateral are required for daily liquidity purposes, consider whether there is a track record of replenishing the portfolio to maintain value and to ensure liquidity. –– Do you intend to perfect a security interest in the securities offered as collateral? Perfection of marketable securities is accomplished through possession, or by control agreements (see Dimension 6 for a detailed discussion of perfecting a security interest in marketable securities and deposits). Taking possession or executing control agreements may hinder the borrower’s ability to use marketable securities or deposits for liquidity purposes. DIMENSION 5 - 11 ACCOUNTS RECEIVABLE AS COLLATERAL NOTES: Account customers. It is critical to understand to whom the borrower is selling and whether these companies are good credit risks. The borrower should have adequate credit procedures in place to manage its exposure, and the overall industry should be healthy. A weakened industry may mean that the borrower is taking higher overall credit risk because of weakened customers. Credit practices. The borrower’s payment terms to its customers must be understood. Liberal returns and allowances policies, frequent or standard prepayments, or progress billings can signal collection problems. Continued shipment to customers in arrears also suggests questionable credit practices. Accuracy. The accounts should be accurately stated. The company should have accounting systems and procedures in place to permit an accurate assessment of the status of the collateral, and fraud protections should be built into administrative procedures. Dilution. Dilution is one of the most important considerations in determining the value of accounts receivable as collateral. Typical causes of dilution include: Allowances, discounts, or co-op advertising. These are examples of negotiated changes to standard pricing. For example, a retailer may earn discounts or allowances based on sales volume levels or in exchange for favorable shelf space. The discount or allowance amount is applied to outstanding receivables, reducing the net value of the receivable balance. Returns. Goods shipped and billed may contain defective merchandise, either in whole or in part. An excessive amount of credits may signal a product quality problem. Credits may be issued in partial payment of an outstanding receivable. Bad debts or write-offs. These may be uncollectible accounts or perhaps individual, disputed sales transactions that are ultimately written off. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral There are two major considerations when determining the value of accounts receivable. The first and obvious consideration is the gross dollar amount of the receivables outstanding, accompanied by analysis of the client’s own historical turnover trends and comparisons to industry peer groups. More important, however, is the intrinsic value of the receivables shown on the borrower’s books. The intrinsic value considers the overall collectibility of the receivables, which is influenced by several factors: DIMENSION 5 - 12 NOTES: Contra accounts. When the borrower both sells to and buys from a company, receivables may be offset by the corresponding payable amount. Although in practice the two parties may continue to pay each other’s invoices, in bankruptcy or if amounts are disputed, the customer/vendor may insist on the offset. Depending on borrower practices and procedures, dilution can range from a very small amount of receivables (5% or less) to much more significant amounts. It is essential to determine a borrower’s dilution experience and to adjust the gross receivables accordingly. EVALUATING ACCOUNTS RECEIVABLE To verify the amount and value of accounts receivable requires specific examination of the borrower’s accounts, plus review of related cash accounts. Asset-based lenders typically require a comprehensive field examination, conducted by qualified audit professionals, to identify any collateral risks and to help establish the appropriate loan-to-value percentages. Even if your financial institution does not have a formal asset-based lending program, it is helpful to understand the scope of an accounts receivable field exam. In the following paragraphs we will describe typical cash and accounts receivable examination tests, which will help increase your understanding of collateral risks and how to assess them. CASH ACCOUNTS EXAM CRC US Body of Knowledge The objective of the cash accounts exam is to determine if cash is being properly received and accounted for and if disbursements are properly documented. The cash accounts exam complements the accounts receivable exam in that it follows the transaction from sale/receivable to collection. DIMENSION 5 - 13 Typical cash accounts exam procedures include: NOTES: Identify unusual disbursements. The examiner looks for any unusual or significant cash disbursements. Such disbursement activity may provide clues to changes in company policies and procedures or prompt questions that could lead to meaningful insights. For example, large payments to attorneys may be retainers to support impending litigation; payments to officers and shareholders may be restricted by loan agreement and in need of verification against covenant formulas. Investigate suspicious transactions. The examiner looks for evidence of fraudulent activity. An experienced examiner may note unusual payment patterns or questionable disbursements that trigger a deeper inquiry. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Verify deposit activity. The examiner verifies that deposit activity correlates to the bank’s understanding of the handling of cash accounts. For example, in the case of a borrower whose ABL facility operates through a cash collateral account, the examiner will verify that all remittances have, in fact, been sent by customers directly to the lockbox. Any exceptions are noted in the exam report, and the examiner checks to determine if those exception items were immediately deposited into the cash collateral account by the borrower. DIMENSION 5 - 14 NOTES: ACCOUNTS RECEIVABLE EXAM The objective of the accounts receivable exam is to determine if the receivables are fairly stated and if they are valid and collectible. There are a number of areas of exposure for loss of accounts receivable collateral value. The most significant include: Bill and hold. The client may receive an order from a customer and book it to accounts receivable, but instead of shipping immediately, holds the goods. Reasons for holding are variable, but they can be as simple as merely waiting for additional instructions from the customer. If funds have been advanced against the receivable and the customer subsequently cancels the order, the collateral is worthless. Prebill. The client bills the customer for goods that have not yet been shipped. Prebilling almost always signals an attempt to overstate sales and receivables. If the client cancels the order or the client fails to ship the goods, the bank’s collateral is worthless. In some circumstances, notably where progress billings are an agreed-on element of the sale, prebilling is not an attempt to create fraudulent collateral. Progress billings need to be evaluated in each circumstance to determine whether they represent advanceable collateral; typically, the answer is no, but arguments can often be made that support acceptance of progress billings as collateral. The relationship between the borrower and its customer is an important determining factor. Partial Shipments. The client bills the customer for a valid order but ships only a portion of the goods. The receivable submitted to the bank for funding represents the entire order, meaning the true collateral is insufficient to cover the full advance against the receivable. CRC US Body of Knowledge Prepayments. The client receives some or all of the payment before shipping the goods. If the client cancels the order, or in the event of client bankruptcy, some or all of the payment may have to be returned to the customer. In that event, the bank’s collateral would be deemed nonexistent. Dilution. Discounts, allowances, returns, contra accounts, and other credits may reduce the collectibility of the stated receivables. These credits may be posted or unposted. A growing balance of credits may signal product quality control issues or sloppy selling practices. Credits can also be fraudulently issued and receivables rebilled to remove delinquent collateral from the aging list. DIMENSION 5 - 15 Poor credit quality. Poor credit practices yield poor collateral. If the client sells consistently to questionable accounts or if overall credit quality deteriorates, the bank’s collateral deteriorates as well. It is important to review credit practices regularly, particularly if there is a significant departure from historical aging or turnover trends. NOTES: Fictitious receivables. The client may submit to the bank for funding receivables that are fictitious, from either a genuine customer or a fictitious account party. In either case, there is obviously no collateral to support the advances. Consignment sales. The client has placed goods on consignment with an account debtor, and these sales are not completed by the client until resale by the account debtor. The client owns the merchandise until its account debtor has sold it, and thus there is not a valid receivable and no collateral to support an advance. Unbilled receivables. The client may have sold goods or provided services, but no invoice has been issued. These may be collectible by the bank and thus used as collateral to support an advance, but there is risk to the bank because the ultimate invoice amount is subject to dispute. Bonded receivables. These are usually receivables from contractors, where the contractor was required to be bonded on a project. If the contractor does not complete the project and instead the bonding agent completes it, the bonding agent will have a priority lien on project receivables. Guaranteed sales. Common when clients sell to retailers, guaranteed sales include contract provisions guaranteeing that if the retailer cannot sell the goods, the vendor (your client) will take them back. Thus sales are contingent and therefore not strong collateral support for advances. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Intercompany receivables. Intercompany receivables are not armslength transactions. In liquidation, the bank may find the account parties not in sympathy with the bank’s need to collect, and/or the value of the receivables may have been overstated. In either case, the collateral value of these receivables is questionable. DIMENSION 5 - 16 NOTES: ACCOUNTS RECEIVABLE EXAM PROCEDURES The receivables examination procedures are designed to identify and quantify the loss exposure areas as outlined in the preceding discussion. Examinations will differ according to bank policies and procedures, as well as in response to specific needs dictated by customer relationships or industry peculiarities. Typical receivables exam procedures include: Reconcile and verify the A/R aging. The examiner reconciles the client’s aging to the client’s general ledger and financial statements, as well as to the reports supplied by the client to the bank to support borrowing requests. The aging should reconcile in each case, and any discrepancies are investigated and reported to the ABL relationship manager. One example of an adjustment that bears further investigation is a credit adjustment to the receivables by the company’s outside accountants. The outside accountant may have deemed the adjusted receivables to be uncollectible. Discrepancies between the company’s internal records and reports filed with the bank may relate simply to timing differences (bank reports as of the 15th of the month; book agings generated at month-end). These discrepancies may, however, indicate tampering with the records to support fraudulent borrowing requests. Verifying the aging means to verify if the accounts are as current as the borrower represents them to be. Verification involves taking sample invoice records from the aging and verifying them with the actual invoices on file. The examiner checks the invoice date, due date, and invoice amounts against what is listed on the aging report. The examiner checks to be sure that the accounts are being aged properly and that old invoices are in fact moved across the aging until they are shown as past due. A comprehensive test includes looking for proof of the order, such as a purchase order, or a note in the file if an invoice is from a verbal order. CRC US Body of Knowledge It is good policy to exclude from collateral all receivables from an account debtor whose balance owed to your client includes 90-day or more past due balances on individual invoices. Verify shipment of goods. Shipping documentation is inspected to verify that shipment took place either the same day or one day prior to the invoice date. Bills of lading should be attached to the invoice, showing that the carrier actually signed for the goods. Quantities shipped are compared as marked on the invoice and on the bill of lading to check for evidence of partial shipments. DIMENSION 5 - 17 Identify customer concentrations. The examiner reviews the agings to determine if there are any significant concentrations of receivables from any one customer. Significant concentrations may mean that the client is exposed to financial difficulty should that business be lost to competitors or the customer fail to pay its invoices. Review credit approval and collection procedures. The examiner reviews the client’s credit approval procedures, including verifying how closely those procedures are followed. Questions asked include how the client sets credit limits; whether credit reporting agency reports are obtained; and whether and how often credit file information is updated. Collection procedure questions include criteria for classifying an account as uncollectible and the timing of write-offs; staffing resources for collection efforts; and general collection procedures. Review management information systems (MIS) adequacy. The examiner reviews the type of automated accounting systems that support the receivables reporting. Focus of the review is to determine whether the systems permit comprehensive and timely reporting of the status of credit sales and whether the overall accounting systems in place contribute to a fair and accurate representation of the company’s receivables. Review bad debt method and reserve adequacy. The examiner reviews the client’s bad debt expense practices to determine if they comply with generally accepted accounting principles (uses the allowance method) or if the client uses the direct write-off method. If the client uses the allowance method, the examiner reviews the adequacy of the allowance for bad debts and reviews the method for determining bad debt expense/the provision for bad debts. Determine industry practices. In some industries extended invoice terms are the norm, and the examiner considers industry practices when evaluating results of agings tests and when reviewing credit and collection practices. NOTES: Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Review the timeliness of payment and credit memo posting. The examiner reviews a sample of payment and credit activity to ensure the documentation is complete and the transactions have been posted in a timely fashion. Credit memos should indicate the original invoice number and the reason for the credit; the examiner looks for indications of continuing product quality problems. The examiner also ensures that credits are posted against their original invoices and not against older invoices to manipulate the past due accounts. DIMENSION 5 - 18 NOTES: EVALUATING NOTES RECEIVABLE Notes receivable are promissory notes payable to your customer and may arise in the course of trade, such as converting an account receivable to a formal note when extended terms are granted. A note may also be the evidence of debt when an owner, employee, or other party receives an advance from the company. Regardless of the reason for the underlying debt, it is important to ask the following questions when evaluating whether to take a promissory note as collateral: Who is the maker (signer) of the note? Does the maker demonstrate both ability and willingness to repay the loan evidenced by the note? What are the terms of the note, including term, payment schedule, and interest rate? If the note currently requires performance, is the debtor making timely payments? Is the note secured, and if so, what are the nature and value of the collateral? Is the note guaranteed, and if so, does the guarantor have the resources and motivation to repay the loan evidenced by the note? Is the note negotiable or non-negotiable? To be negotiable, the note must be in writing, signed by the debtor, contain an unconditional promise to pay the named amount, and be payable either on demand or at a specified date. Most important, the note must be payable either “to the order of [XYZ Company]” or “to bearer.” If payable to a named creditor only (payable to XYZ Company) the note is not negotiable. CRC US Body of Knowledge The bank can take either a negotiable or a non-negotiable note as collateral, but the bank has greater flexibility in disposing of the note (perhaps selling it) and greater protections in defense of taking the note as collateral if it is a negotiable note. DIMENSION 5 - 19 INVENTORY AS COLLATERAL NOTES: The quality of inventory as collateral is measured in a number of dimensions. Some of these areas are related to complex inventory accounting considerations outside the scope of this reading. In general, key considerations include: If you are lending on a formal borrowing base, one significant risk is that the borrower may reclassify one component of inventory to another for the fraudulent purpose of increasing the advance rate on the collateral. For example, when the bank does not advance funds against work-in-process inventory, the borrower may prematurely advance not-quite-finished goods into finished goods to qualify them for working capital advances. Marketability of the bank’s collateral may be nonexistent if the product cannot be sold in an incomplete condition. See the “‘General Collateral Guidelines” discussion following for collateral considerations by class of inventory. Costing/accounting methods. The true cost of the inventory needs to be considered. When inventory advances are structured as a percentage of funds loaned against the inventory’s cost, understanding the inventory cost is essential. In many instances soft costs, such as overhead components, can be absorbed into inventory cost figures. Similarly, if freight is a large component of inventory cost, liquidation value will be impaired. The lender needs to verify that costing methods used are reasonable and that the carrying cost on the books reflects an accurate cost or market value, whichever is less. There is also the risk of deliberate overstatement of quantity or value. Fictitious inventory reports may be submitted, overstating the quantity of inventory on hand and thus diluting the bank’s true collateral value. Alternatively, costs to produce the inventory may be overstated or if the market value of the inventory has deteriorated, write-downs may not have been taken. In either of these cases, the bank’s advances, typically tied to inventory cost, will be excessive in comparison to the realizable collateral value. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Contents. Inventory is often comprised of multiple components, such as raw materials, work-in-process, and finished goods inventory. Generally, these components do not have equal value, so it is important to determine how much of overall inventory is represented by each of these components. DIMENSION 5 - 20 NOTES: Physical condition. The inventory should be fresh and in salable condition. Accordingly, it should be stored properly, kept in good condition, and sprinkler systems and security procedures should be appropriate to the nature of the inventory. Perishable inventory requires extra care and shortens the window of opportunity for liquidation. Keep in mind that in a liquidation, the bank will need to take responsibility for maintaining the condition of the inventory until it is sold. Inventory that requires costly care and maintenance will yield smaller proceeds, net of the incremental handling costs. Marketability. The inventory should be easily marketable. There should be good distribution channels to facilitate sales. The current state of the industry must also be considered, including whether there is an excess or shortage of the product on the market, or whether a new or substitute product is diverting sales. Marketability impairments include being outdated or out of style, obsolete (or approaching obsolescence), requiring significant time or funds to complete, or being highly customized or specialized. Note that some types of inventory may not be legally marketed by the bank, such as alcohol or tobacco products. The worst-case scrap value of the inventory (by component) should be estimated to determine the lowest likely value to be realized in liquidation. Significant quantities of inventory tagged as returned or defective indicate impaired marketability. CRC US Body of Knowledge Verifiability and control. Verification of inventory value is another key consideration. Tests to confirm inventory value are important to ensuring that the value of the collateral is as represented by the borrower. Some inventory may not be the borrower’s property at all, such as tool and die property on the borrower’s premises but owned by the company’s customers. In addition, the lender must evaluate the borrower’s inventory control systems to confirm that the borrower’s ongoing representations of collateral types, values, and locations can be relied on. Ready access to inventory is key to realizing proceeds in a liquidation. The borrower must be able to demonstrate adequate control and tracking of inventory, i.e., be able to identify quantities by type and location and to regularly update this information. In the event of a liquidation, it is essential to have quick access to accurate records, so the bank can take control of the collateral in time to prevent any shrinkage while trying to verify its content and location. In addition, if there are special systems or equipment needed to maintain the inventory in salable condition (such as refrigeration units or security systems) it is best practice to ensure the bank has legal access to these systems, so it can maintain the assets during a workout or liquidation process. DIMENSION 5 - 21 Domicile. The bank must have legal and practical access to the inventory. Where the inventory is located has implications for both. Inventory located outside the country, or located at the site of the borrower’s customer may present physical access difficulties. Inventory located out of the country may require hiring in-country legal counsel for access and disposal. For a detailed discussion of lien perfection procedures, including information about filing liens when the collateral is outside the borrower’s state of domicile, see Dimension 6. NOTES: Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Inventory that is not under proper security and control is subject to physical removal from the customer’s premises. To the extent the book value of the inventory is overstated by the pilfered amount, the bank’s collateral is undervalued with respect to advances against it. DIMENSION 5 - 22 NOTES: COLLATERAL GUIDELINES FOR INVENTORY COMPONENTS There are no universal guidelines for acceptability of inventory components as collateral. Conventional wisdom suggests that finished goods inventory is the most valuable, followed by raw materials; in most cases, it is assumed that work-in-process inventory will yield little or no value to the lender in collateral liquidation. Conventional wisdom is often valid, but there can be exceptions. General considerations for each class of inventory, with some notable exceptions you should evaluate, are: Raw materials. Raw materials inventory can be interesting to the lender because the cost is generally easily identified. Particularly if the raw materials are a commodity product, there can be an easily identifiable market for resale (although commodity goods are highly subject to price volatility, making value in liquidation difficult to estimate). Viewing the raw material as another company’s finished goods (where appropriate) can cast a more favorable light on this inventory component’s marketability. Exceptions: Raw material can be purchased partially processed, as in lumber cut to specific board lengths. In that case, the resale market is less clear. CRC US Body of Knowledge Work-in-process. Costs can be difficult to define, depending on accounting conventions and at what state labor and overhead are imputed into the product. Unless there are similar competitors, an outlet for unfinished product may not exist, and any sale can be expected to yield minimal dollar value. Exceptions: A manufacturer of custom machinery may progress-bill its customers. Where progress billing is a contractual obligation, the work-in-process (partially completed machines) may be viewed by some lenders as pre-sold inventory, with correspondingly high collateral value. Finished goods. Generally viewed as having the most assured liquidation value, finished goods inventory has an identifiable market and sale price. Cost can be difficult to determine, depending on accounting conventions. DIMENSION 5 - 23 Exceptions: If the borrower is a dominant player in its industry, unloading the finished goods in liquidation may result in significantly depressed sales values as supply potentially outpaces demand. In addition, there are many factors that can influence the liquidation outcome, including product perishability, commodity versus specialized product type, seasonality/sales timing, and cost of disposition. Private label finished goods are poor collateral, unless manufactured to specific contracts that have a high likelihood of being honored NOTES: Your inventory evaluation can include an onsite inspection (or several, if inventory is in multiple locations), review of customer inventory reports, or review of third party reports such as an inventory appraisal or an asset-based lending field exam report. Usually a combination of these methods is needed to adequately qualify inventory as collateral. Evaluating inventory entails identifying any risks related to inventory contents and costing/accounting methods. In the paragraphs to follow, we will describe asset-based lenders’ typical inventory examination objectives and procedures to help explain the nature of inquiry needed to identify inventory risks and to determine the appropriate loan-tovalue advance percentage. Whether you are employing the services of a third party inventory appraiser or field examiner, or you are conducting your own investigation, it is important to cover this full range of investigational topics to fully qualify your collateral. In addition to profiling typical inventory exam procedures, we will also describe procedures for examining the borrower’s accounts payable and tax accounts. These support exam elements complement the inventory examination; they help verify that there are no hidden claims against the proceeds of the sale of inventory collateral. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral EVALUATING INVENTORY DIMENSION 5 - 24 NOTES: INVENTORY EXAM PURPOSE AND PROCEDURES The objective of the inventory exam is to determine if the borrower’s representation of inventory is accurate and to assess the adequacy of the inventory as collateral for the company’s borrowings. There are a number of areas of exposure for loss of inventory collateral value, which we described at the beginning of this inventory discussion. The inventory examination procedures are designed to identify and quantify the inventory loss exposure areas as outlined in the preceding discussion. Examinations differ according to bank policies and procedures, as well as in response to specific needs dictated by customer relationships or industry peculiarities. Typical inventory exam procedures include: Analyze components. The examiner verifies the classes of inventory, generally raw material, work-in-process, and finished goods. A complete review of inventory components requires an understanding of the inventory conversion cycle to determine if movement of inventory from one class to another is consistent with the actual changes in the value added to the goods. Test cost of sales. The examiner reviews the method used to determine inventory cost, plus any general ledger adjustments. Adjustments are analyzed to determine if they fairly reflect the actual cost of the inventory on the books. CRC US Body of Knowledge Confirm valuation. The examiner reviews valuation procedures and verifies that the inventory is being carried at the lower of cost or market. Sale value is compared with inventory value (cost) to determine margins and to verify the goods are salable above cost. Assess marketability. The examiner reviews the overall inventory marketability, including distribution channels, gross profit margin analysis, comments regarding the general state of the industry, and a worst-case scrap value assessment. This review can include researching market trends, and includes analyzing the inventory to determine the percentage of inventory consisting of less marketable elements such as prior year’s models, styles, etc. Validate quantity. The examiner conducts a test count of inventory, noting variances and recording explanations for them. The examiner generally reviews and comments on the overall reasonableness of the client’s inventory tracking methods. Evaluate physical condition. The examiner assesses the general physical condition of the inventory, noting any storage conditions or security lapses that could cause the inventory to deteriorate. Identify obsolescence. The examiner reviews the inventory for DIMENSION 5 - 25 obsolete and unsalable merchandise, noting particularly whether inventory ledger adjustments have been made to reflect the diminished value. NOTES: Review Management Information Systems Adequacy. The examiner reviews the type of accounting systems that support the inventory tracking and reporting. Focus of the review is to determine whether the systems permit accurate and timely assessment of the quantity and value of inventory. ACCOUNTS PAYABLE/TAXES EXAM OBJECTIVES AND PROCEDURES The objective of the examination of payables and taxes is to verify that all trade creditors and taxing authorities are being paid as required. Analysis of payables practices shows the effective leverage of inventory. Verification of tax payments is important because liens for unpaid taxes may have precedence over secured creditor liens. The payables and taxes examination procedures are designed to verify outstanding payables balances and to compare payment practices with agreed-on terms. Examinations differ according to bank policies and procedures. Typical payables/taxes procedures include: Review the A/P aging. The examiner reviews the client’s payables aging to determine if obligations are being met on a timely basis. Note is made of any intercompany payables, and agings are generally compared with similar prior periods. Identify payables concentrations. The examiner looks for any concentration of payables, which may indicate over reliance on a vendor or short supply of needed goods for manufacture or resale. Identify contra accounts. Vendors who are also customers are identified, and their receivable balance compared with the payable balance. The receivable amounts generally will be considered ineligible for financing. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Identify ineligibles. The examiner makes note of any inventory categories that are not eligible for working capital advances and verifies these items have not been included with other eligible inventory on the borrowing certificates. For new or prospective clients, the examiner will formulate specific recommendations for portions of inventory that should not be eligible for financing. DIMENSION 5 - 26 NOTES: Review payment terms. The examiner reviews payment terms for significant vendors to determine if any unusual terms exist and to determine if any trade payables have been converted to notes payable. Verify tax payments. The examiner reviews tax returns and canceled checks to verify the tax amounts due were actually paid, and on time. Federal, state, and local income taxes are checked, as are withholding amounts, payroll taxes, and personal property taxes. PLANT AND EQUIPMENT AS COLLATERAL GENERAL PLANT AND EQUIPMENT QUESTIONS General questions to consider when evaluating plant and equipment include: Are facilities owned or leased? What is the location? What are lease terms, including options and renewals? Is any portion being financed? If so, who has the security interest? In terms of environmental hazard issues, has there been any history of toxic waste disposal or storage on the property? CRC US Body of Knowledge To the borrower’s knowledge, has there been any evidence of environmental hazard or event on any of the surrounding properties within at least five miles? Has the property ever had an environmental assessment? When and who performed it? Would a copy of the assessment be available to the bank? Is the current facility adequate to meet future needs? Has there been a recent appraisal? What value was given to the property and equipment? DIMENSION 5 - 27 EVALUATING EQUIPMENT The value of equipment as a secondary repayment source depends on the following key considerations: NOTES: What is the age of the equipment? Newer equipment obviously provides greater collateral value than older equipment, and its value is generally easier to determine. Of equal importance is to ask how much of the equipment’s useful life has already expired. A two-year old machine that has a service life of only three years may be less valuable as collateral than a five-year old machine with a service life of 20 years. In a similar vein, equipment with remaining (and transferable) warranty protection may have more liquidation value than equipment without warranty protection. Is the equipment portable? Equipment that is permanently or semipermanently affixed to real property presents liquidation problems. There may be legal issues regarding landlord rights if the real property is leased, and there will be costs and practical issues related to securing and transporting the equipment for sale. Is the equipment essential to the customer’s operation? Equipment that is essential to operations is likely to be better maintained than non-essential equipment, preserving collateral value. Also, if the loan is explicitly to finance equipment, loans for essential equipment are less susceptible to default than loans to finance non-essential equipment. Is the equipment uniquely identifiable? If there is a serial number or other characteristic that provides ready identification, the specific equipment serving as collateral will be easily determined. This is particularly important if there is a mix of lenders, or if some of the customer’s equipment is leased from other financing sources. Is the equipment easy to maintain? If maintenance is simple and maintenance costs are low, it is more likely the equipment will remain in good condition and thus retain its collateral value. What is the current condition of the equipment? Equipment in good condition has greater value, and it is also suggestive of the customer’s operational management practices. Similarly, it is important to find out in what setting the equipment is being used. Equipment being used in a very dusty or corrosive environment will not retain value as well as equipment used in a clean, climate-controlled building. Equipment used by companies that do not commit adequate maintenance training and resources will not hold its value. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Is the equipment general purpose or specialized? General purpose equipment has broad application inside and outside the customer’s industry, where special purpose equipment has a very narrow market. DIMENSION 5 - 28 NOTES: Is the equipment comprised of a few significant pieces of equipment or are there many smaller units? Handling and disposal costs are less if the equipment is concentrated, and costs can be significantly higher to liquidate a large number of small-value items. Does the equipment have a low rate of obsolescence? Equipment subject to little obsolescence has a higher value as collateral than equipment that will rapidly lose value in favor of newer technology. Also find out if there is any regulatory legislation existing or pending that will require expensive modification or even phase-out of the equipment. Is there an active secondary market for the equipment? The liquidation value of equipment may be readily estimated if there is an active secondary market in the equipment, and less time will be needed to market the equipment in liquidation. Is there a shortage or a surplus of this type of equipment in the customer’s industry? A shortage suggests easier disposal at higher values; a surplus may suggest the equipment is no longer desirable, or is being phased out in favor of newer or alternate technology. In either of the latter circumstances, liquidation value is impaired. How do current industry trends impact the value of the equipment? For example, if an industry is in distress and there are consolidations, bankruptcies or downsizings in process, value of equipment used in production or manufactured as products by the industry may experience value loss as surplus equipment enters the market. REVIEWING AN EQUIPMENT APPRAISAL When reviewing an equipment appraisal, key questions to consider include: CRC US Body of Knowledge What are the appraiser’s credentials? There are several certifying bodies for equipment appraisers, including: –– Association of Machinery and Equipment Appraisers. –– American Society of Appraisers. –– North American Association of Equipment Appraisers. DIMENSION 5 - 29 In addition, there are appraisal bodies that specialize in particular types of equipment, such as the American Association of Farm Equipment Appraisers. In a formal equipment appraisal, the appraiser should identify his or her professional certification and memberships. Some of the certifying bodies provide multiple levels of certification (i.e., Certified Appraiser I, II, etc.). Several bodies subscribe to The Appraisal Foundation’s Uniform Standards of Professional Appraisal Practice (USPAP), which also governs real estate appraisal practices. NOTES: What is the purpose of valuation provided in the appraisal? The most common values specified are: –– Fair market value. The price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts in the open market. –– Orderly liquidation value. The amount of gross proceeds that could be expected from the sale of appraised assets under orderly conditions given a period of time in which to find a purchaser considering a complete sale of all assets, as is, where is and all sales made free of all liens and encumbrances. –– Forced liquidation value. The estimated gross dollar amount that could typically be realized by a properly conducted public auction held under forced conditions under present day economic trends. –– The valuation most commonly requested by financial institutions for collateral assessment is an orderly liquidation value. Has the appraiser certified that he/she: –– Performed a personal inspection of the equipment? –– Engaged in appropriate investigation and research, including evaluation of comparable equipment being offered for sale and actual previous sale data? –– Charged an appraisal fee that was not contingent upon any value estimate, and has no present or contemplated future interest in the property or the appraisal client that might tend to prevent making a fair and unbiased appraisal Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral The appraiser’s statement of credentials should also include educational credentials and a brief description of professional experience, with any specialized knowledge and experience with relevant types of equipment noted. DIMENSION 5 - 30 NOTES: Has the appraiser provided definitions to explain what is meant by descriptive terms such as excellent, very good, good, fair, poor, and scrap when describing the condition of appraised equipment? Has the appraiser commented on the collateral considerations noted under “Evaluating Collateral” prior? The appraisal narrative should discuss the value implication of many of the considerations we noted as having an impact on the value of equipment as collateral. PROTECTING YOUR ACCESS TO EQUIPMENT COLLATERAL You must order lien searches and obtain copies of all filings to determine whether you have or will have senior liens on collateral. Searches must be ordered from all locations in all states where financing statement filings are required at the time the loan is made. See Dimension 6 for a discussion of how to perfect a security interest in many types of property. Information about environmental assessments is also included in Dimension 6. In addition, it is important to verify that adequate insurance is in place to protect the lender’s interest in the assets. Insurance questions to ask include: What kinds of coverage are maintained? What is the extent of coverage? Are all premiums current? Who is the company’s agent or broker? CRC US Body of Knowledge What is the nature and extent of claims filed in recent years? Are there any pending settlements? Many factors that could negatively affect the value of your collateral and the ability of the borrower to repay its loan are unavoidable and cannot be insured against. For those factors that can be insured against, require proof that such insurance has been obtained and that your institution is an included insured party. Generally you should prefer that your bank be named as loss payee under a New York Standard Mortgagee clause. It provides that your right to coverage under the policy would not be affected or defeated by any act, neglect, or default of the borrower. DIMENSION 5 - 31 INTANGIBLE ASSETS AS COLLATERAL NOTES: Marketing-related intangible assets. Typically these are trademarks and trade names that provide value through the owner’s ability to attract customers and/or charge a premium based on perceived benefits associated with the name. Customer-related intangible assets, such as customer lists and sales contracts. This type of intangible is most valuable in industries for which obtaining customers is a significant barrier to entry. For example, major grocery stores frequently buy their produce only from established brokers. Once established, the broker’s customer list is very valuable. Another example of customer-related intangible assets is the customer maintenance contracts commonly owned by software companies. Covenants not to compete are also customer-related intangible assets. Artistic-related intangible assets, such as copyrights that provide value by establishing exclusive right to sell or license a work. Contract-based intangible assets, such as intellectual property licensed from another entity. One example would be a clothing retailer that owned the rights to use the Olympic rings in its clothing. A franchise agreement or a company’s internet domain name might also be considered contract-based intangible assets. Technology-based intangible assets, more commonly referred to as patented technology, and including software. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Intangible assets, like all assets, are claims to future values. Tangible assets represent either physical value claims (such as equipment or real estate) or financial claims (such as an account receivable, which represents a claim to future cash). Intangible assets represent nonphysical claims to future values and are generally recognized to fall into four categories: DIMENSION 5 - 32 NOTES: There is great variation in terminology used to define intangible assets. For example: General intangibles as defined in Article 9 of the Uniform Commercial Code means “any personal property, including things in action, other than accounts, chattel paper, commercial tort claims, deposit accounts, documents, goods, instruments, investment property, letter-of-credit rights, letters of credit, money, and oil, gas, or other minerals before extraction. The term includes payment intangibles and software.” Payment intangible is defined by Article 9 as “a general intangible under which the account debtor’s principal obligation is a monetary obligation.” Accounting rules distinguish between intangible assets with finite (such as patents) or indefinite lives (such as goodwill). Lenders often add to the list of intangibles balance sheet accounts of dubious value, such as notes receivable from or investments in affiliated entities, when adjusting reported net worth to what we call tangible net worth. Assets such as those named above—trademarks, trade names, customer lists, sales contracts, copyrights, licenses, and patents—are commonly referred to as intellectual property (IP). CRC US Body of Knowledge For the purposes of this collateral analysis discussion, we will limit the topic to the intellectual property intangibles defined earlier. Most other assets included in the broader definitions, such as payment intangibles, have readily identifiable values. Others, such as goodwill, have values that are identifiable, but not separable from the owning entity, and thus do not typically provide collateral value. DIMENSION 5 - 33 IDENTIFYING INTANGIBLES SUITABLE AS COLLATERAL NOTES: Does the asset have value independent of the owning entity? Patents, trademarks, copyrights, trade secrets, customer lists, and software are examples of intangibles that typically can be separated from the owning entity, i.e., can be sold. Goodwill generally does not have independent value, although for legal reasons it is advisable to take a security interest in associated goodwill when securing certain assets, such as trademarks. Has a value been established for the asset? If so, how was the value established? Accounting rules for intangible assets require annual impairment tests and related value write-downs if an impairment has occurred. However, balance sheet value does not permit recognition of increased market value, which generally can only be reliably established through a formal valuation process. Appraisers of intellectual property and other intangible assets should be credentialed. The Appraisal Foundation’s Uniform Standards of Professional Appraisal Practice (USPAP) apply to intellectual property valuations. Valuation of intangible assets may be based on cost, market, or discounted future cash flow approaches, similar to valuation of other assets. Each approach requires market specialists capable of performing independent research, with specialized knowledge of the borrower’s competitive environment, similar intellectual property in the industry, and recent sales or licensing of similar property. Has the asset been afforded all relevant legal protections, such as registration with the appropriate government agency? Some types of intellectual property, such as patents, need to be registered to protect rights. Other property, such as a copyright, does not require registration but registration is the best means of enforcing a claim of infringement against a third party. Generally, the more legal protections in place, the more likely the asset will provide value in a liquidation. Does the borrower actually own the asset? You should verify that the company has full legal ownership rights in its intellectual property. Licensed intellectual property may not be transferable. Even if a company paid for development of a proprietary copyrighted work, it may not have full ownership rights if the property is considered a work for hire and the company did not secure the appropriate assignments of copyright interest. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Not all intangibles are suitable as collateral, including some intellectual property. To identify intangibles suitable as potential collateral, consider the following questions: DIMENSION 5 - 34 NOTES: Has the asset previously been used as collateral? If your customer provided intellectual property as collateral for an earlier financing, it is possible that the lender’s security agreement was effectively a means to assign the asset to the lender while licensing it back to the borrower. Ownership of the asset may have transferred to the lender in that event. What are the costs to maintain legal protections if the asset is intellectual property? Maintaining and defending legal protections can be very expensive. Patent, trademark and other legal protections have indefinite lives and require additional filings and fees to keep them in force. Defense of intellectual property infringement is expensive, both to protect the borrower’s property and to respond to suits alleging the borrower infringed on similar or pre-existing property. Have contract rights been thoroughly documented, and do they include any restrictions on sale, pledge, or assignment? For both registered intellectual property and intangibles such as non-compete agreements and long-term supplier contracts, you should request information to determine whether there are any express restrictions on your ability to secure and perfect an interest in the asset. In rare cases, financial statement disclosures may provide relevant details, but generally you must request review of the relevant documents. UNDERSTANDING THE REAL ESTATE APPRAISAL APPRAISAL DEFINITION CRC US Body of Knowledge An appraisal of real property provides an estimate of the value of the property as of a defined point in time, based on current market conditions. Regulatory agencies have mandated the use of appraisals in real estate lending decisions and have stipulated the basic information that an appraisal must contain. Regulatory requirements notwithstanding, for the lender the appraisal is one of the more important underwriting tools. It provides very useful information on: Overall market conditions. Characteristics of the particular neighborhood in which the property is located. Current market rental rates and operating expenses. Value of land and any improvements. DIMENSION 5 - 35 This discussion will familiarize you with the critical analytical content of the appraisal, its sequencing and the basic concepts or rationale for each appraisal section. You will normally find conclusions presented at the beginning and end of the report, with the salient supporting data and arguments laid out in the middle. This is a fairly high-level discussion, as the actual content of an appraisal is much more comprehensive than as outlined here. Appraisal content not discussed in this section may include photographs of the site, site/ parcel descriptions, project descriptions, title/lien priority data, surveys, etc. It is easy to see how on larger, complex projects appraisals can be 100 pages or more in length. Regardless of the length, a comprehensive review of the appraisal constitutes essential due diligence on any commercial real estate loan. The major appraisal sections addressed in this section are: Highest and Best Use. Three Approaches to Value. Cost Approach Sales Comparison Approach. Income Capitalization Approach. Final Reconciliation of Value. NOTES: Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral KEY APPRAISAL CONTENT DIMENSION 5 - 36 NOTES: HIGHEST AND BEST USE Highest and Best Use analysis is the balance point of the appraisal process and the appraisal report. In this analysis, the appraiser reconciles the economic and physical information presented in the beginning of the report and asks two questions about the subject: 1. If the site were vacant, what would the optimum improvement be? 2. If the subject is improved, how do the existing improvements relate to the optimum improvement and current market expectations? The answers to these questions provide the foundation for the approaches to value the appraiser ultimately uses, as well as for the information considered in the valuation section of the report. Application of the highest-and-best-use concept can be extremely involved and indeed requires a high level of analysis on the appraiser’s part. It is not a task to be undertaken by the uncredentialed real estate professional. However, the basic concept is fairly straightforward and focuses on the optimal value potential for the property. The following explanation paraphrases the concept. HIGHEST AND BEST USE IS: The reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and which results in the highest value. The highest and best use must meet: legal permissibility, physical possibility, financial feasibility, and maximum profitability. The highest-and-best-use analysis of a site always focuses on the site as if it were vacant and available to be put to its best use on a specified date, irrespective of its current use. The highest and best use of an improved property focuses on what exists or will exist. CRC US Body of Knowledge NOT THE HIGHEST AND BEST USE If the appraiser concludes that the existing or proposed improvements are not the highest and best use, the conclusion implies that some obsolescence is likely. The property may no longer make economic sense. The improvements will not result in the highest market value of the property. For example, imagine a small single-family residence on two acres in what was once a remote locale. Over time, urban and suburban sprawl have surrounded this property with high-density commercial development. Clearly the single family home does not maximize the utility and economic potential of the property. It is not the highest and best use. DIMENSION 5 - 37 APPRAISALS: THE THREE APPROACHES TO VALUE NOTES: Appraisals are only one tool in a lender’s toolbox. While appraisals are essential to making good real estate underwriting decisions, appraisers can and do make mistakes. Only by reading the appraisal, viewing the property, and combining good business sense with common sense and judgment can an appropriate decision be made regarding the loan. Remember: The appraisal alone will not determine the collectibility of your financing. Standards of professional appraisal practice require that for most types of property, the appraiser must use three separate methods to estimate value. These methods are called the cost approach, the sales comparison approach (also called the market approach), and the income capitalization approach. The appraiser analyzes the values estimated with each method and then uses his or her judgment to correlate a final value. Note: There can be circumstances in which the appraiser finds that one of these approaches is not applicable. One example is the appraisal of a parcel of vacant land on which no improvements have been constructed. Since the property is not generating income, the income approach is not applicable, nor is the cost approach, since there are no improvements on the property. In this example, the appraiser would use only the sales comparison approach, in which sales of comparable parcels of unimproved land are analyzed. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral THREE APPROACHES TO VALUE DIMENSION 5 - 38 NOTES: TYPES OF VALUE An appraisal of real property provides an estimate of the value of the property as of a defined point in time, based on current market conditions. As the appraisal provides time-sensitive analysis, there are many measures of value for a given property. The value will be a function of the property’s completion status, lease status, anticipated premises for sale (e.g., liquidation), and so on. In ordering the appraisal, you should be very clear about what values you are requiring. Several definitions of value are: As is value: See Value As Is (following). As built-out value: See Value Upon Completion (following). Bulk market value: A misnomer; see also Gross Selling Price, Value upon Completion and Value to a Single Purchaser (following). Market value: The most probable price a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus. Implicit in this definition is consummation of a sale as of a specified date and passing of title from seller to buyer under the following conditions: Buyer and seller are typically motivated. Both parties are well informed or well advised and acting in what they consider their own best interest. A reasonable time is allowed for exposure in the open market. Payment is made in terms of cash in U.S. dollars or in terms of comparable financial arrangements. CRC US Body of Knowledge The price represents the normal consideration for the property sold, unaffected by special or creative financing or sales concessions granted by anyone associated with the sale. DIMENSION 5 - 39 Present value: The lump sum amount that represents the current value of the right to collect future payments. NOTES: Prospective value estimate: A forecast of the most probable value expected to occur at a specified future date. It is most frequently used in connection with real estate projects that are proposed, under construction, under conversion to a new use or that have otherwise not achieved sellout or a stabilized level of long-term occupancy at the time the appraisal report is written. Transaction value: Means: For loans or other extensions of credit, the amount of the loan or extension of credit. For sales, leases, purchases, and investments in or exchanges of real property, the market value of the real property interest involved. For the pooling of loans or interests in real property for resale or purchase, the amount of the loan or market value of the real property calculated with respect to each such loan or interest in real property. Value as is: The value of specific ownership rights to what physically exists and is legally permissible on an identified parcel of real estate as of the date an appraisal is written or the subject property was last inspected. Value to a single purchaser: The price as of a specified date that a single purchaser could be expected to pay for a real estate project in which a portion of the overall rights in realty are expected to be sold to individual end users over time. Value to a single purchaser implies that an informed purchaser would pay no more for a project at a specific point in time than the price at which he could acquire the property and cover all remaining direct or indirect costs expected to be incurred before sellout of all remaining units or lots. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral It is always based on the expectations and perceptions of market participants together with identifiable and documentable trends as well as data that are known or knowable at the time the forecast is made, and is a prediction. DIMENSION 5 - 40 NOTES: Costs expected to be incurred in the achievement of sellout may include (but are not necessarily limited to) all remaining costs associated with completing construction or development. Additional sellout costs can include anticipated costs associated with marketing individual units or lots and maintaining the property during the absorption period—the cost of mortgage and equity capital expected to be incurred, plus a market-based level of entrepreneurial profit. Value as if completed: The hypothetical value of a property as if all proposed improvements, development, rehabilitation, modernization, remodeling or changes in use were accomplished on the appraisal date. Value upon completion: The prospective value of the expected physical and legal position of an identified parcel of real estate on the date when any development, rehabilitation, modernization, remodeling or change in use has been physically accomplished. This is a prospective value estimate predicated upon known or knowable data as well as the expectations of typically informed market participants as perceived on the date the appraisal is written. Value upon stabilized occupancy: The prospective market value of the expected physical and legal condition of an identified parcel of real estate on the date when any development, rehabilitation, modernization, remodeling, or change in use has been physically accomplished and the property has attained its expected level of longterm occupancy. It contemplates a value estimate of the total ownership rights to the expected physical and legal condition of an identified parcel of real estate. It reflects the highest and best use of the expected physical and legal condition of the identified property rights on the prospective date of the value estimate. It reflects the long-term economic feasibility of the identified property because it will physically and legally exist on the prospective date of the value estimate. CRC US Body of Knowledge It is a prospective value estimate predicated upon known or knowable data as well as the expectations of typically informed market participants as perceived on the date the appraisal is written. Wholesale value: A misnomer; see value to a single purchaser. DIMENSION 5 - 41 COST APPROACH NOTES: BASIC CONCEPT OF THE COST APPROACH The cost approach determines the value of the property based on its cost to complete, less depreciation. This approach is used any time there are improvements constructed on a piece of property. The only time this standard does not apply is when the appraiser determines that the improvements do not contribute any value to the property because of deterioration, deferred maintenance, obsolescence, or other factors. The appraiser executes three basic steps in completing the cost approach. Estimate the value of the land as if it was vacant. Determine the replacement or reproduction costs of the improvements, less any accrued depreciation. Sum the land value and the depreciated cost of the improvements to determine the value of the property. An example follows: Estimated land value if vacant $ 50,000 Estimated construction cost of a similar structure $160,000 Less estimated depreciation ($ 10,000) Equals estimated value of building $150,000 Appraised property value $200,000 To estimate the land value, the appraiser analyzes recent sales of vacant land similar to the property being appraised. Considerations for similarity include time of sale, zoning, size, location, topography, and access. Because two parcels of land are rarely exactly alike, the appraiser makes adjustments to the sales price of each comparable property to reconcile its value more closely to that of the subject property. To estimate the value of the improvements, the appraiser uses one of various construction cost-estimating guides to determine the reproduction costs of the type of property being analyzed. One of the most commonly used cost sources is the Marshall and Swift Valuation Service. The cost guides classify properties according to the quality of design and construction, such as fair, good, very good, and excellent. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral THE PROCESS FOR THE COST APPROACH DIMENSION 5 - 42 NOTES: This analysis provides a value of the improvements as if they were new. To estimate depreciation, the appraiser states whether the property suffers from any of four types of depreciation: Curable physical deterioration, resulting from deferred maintenance, which can be repaired. Incurable deterioration that cannot be practically or economically corrected. Functional obsolescence or a loss in value stemming from the design of the building; may be caused by changes over time that make certain materials or a design obsolete. Economic obsolescence or the diminished utility of a structure because of outside influences, such as a declining neighborhood or depressed market conditions. To arrive at an overall value of the property under the cost approach, the appraiser simply sums the land value and the cost of reproducing the improvements, minus any depreciation. TIPS FOR REVIEWING THE COST APPROACH Review the land comparables to ensure that appropriate properties have been analyzed. Focus on the timing of the previous land sales. Real estate conditions can change rapidly, and a sale in excess of 12 months old may not reflect current market conditions. If the appraiser feels that market conditions have changed since the time of the sale, he or she should adjust the value accordingly. CRC US Body of Knowledge Assess reasonableness of all adjustments made by the appraiser in determining the value. Verify that the appraiser’s description of the quality of the improvements is properly reflected in the calculation of construction cost. DIMENSION 5 - 43 SALES COMPARISON APPROACH BASIC CONCEPT OF THE SALES COMPARISON APPROACH NOTES: In the sales comparison approach, also known as the market approach, the appraiser determines the value of the property based on the prices at which other comparable properties have changed hands. The appraiser executes five basic steps in completing the sales comparison approach. Search property sales records in a geographic area and extract an adequate number of properties similar to the subject that have recently been sold. Compare the subject property to those selected sales comparables (i.e., properties that possess similar characteristics). Determine an applicable unit of comparison to use in the analysis. Depending on the type of property, the unit of comparison may be the sales price per square foot of building area, the sales price per acre of land, the sales price per unit (for apartments and hotels), or a similar appropriate calculation. The appraiser may also extract the gross income multiplier (GIM) from the sale of income property. The GIM is calculated by dividing the annual gross income generated from the property by the sales price of the property. For example: a commercial property recently sold for $350,000 and the gross annual income is $50,000. The GIM would be 7 ($350,000 / $50,000 = 7). Compare each comparable to the subject and adjust each comparable sale (up or down) for various characteristics, including the time of the sale, size of the property, zoning, access, age, location, design, physical characteristics, and quality of construction. Based on this analysis of the comparable sales, determine the value of the appropriate unit of comparison and multiply the unit of comparison by the size of the subject property to determine the value in accordance with the sales comparison approach. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral THE PROCESS FOR THE SALES COMPARISON APPROACH DIMENSION 5 - 44 NOTES: TIPS FOR REVIEWING THE SALES COMPARISON APPROACH Carefully review the description and location of each comparable property to determine if it is truly similar to the subject property. Focus on the timing of each comparable and verify that older transactions have been appropriately discounted in the weighting for that factor. Examine each comparable adjustment to see that they are reasonable, well-supported, and consistent. THE INCOME CAPITALIZATION APPROACH CONCEPT OF THE INCOME CAPITALIZATION APPROACH The income capitalization approach, or cash flow approach, is critical in the valuation of income-producing properties. This method determines the value of the property based on its cash flow generating ability, or earnings power. The income capitalization approach converts future income expectancies into a stabilized value estimate. An estimate of property cash flow is established, the quality of the cash flow stream is assessed, and an investor rate of return is applied to the cash flow stream to calculate the value of the property. CRC US Body of Knowledge In compiling the data required for this analysis, the due diligence procedures of independent confirmation apply. The appraiser will use actual lease documents on the subject and comparable properties as available, as well as data from other developers, investors, appraisers and real estate brokers. The data obtained will also be compared to the estimates of future property performance provided by the owner/ developer. DIMENSION 5 - 45 THE PROCESS FOR THE INCOME CAPITALIZATION APPROACH NOTES: The appraiser executes six basic steps in completing the income capitalization approach. Each step is discussed in greater detail following. 1. Determine the property square footage. 3. Deduct costs for vacancy and collection loss. 4. Deduct costs for operating expenses. 5. By subtotaling, calculate the property net operating income (NOI), or property cash flow. 6. Convert the net operating income (NOI) into a value estimate by applying a rate of return, or capitalization rate. 7. The income capitalization process and its relating calculations are demonstrated on the Income Property Cash Flow Worksheet using a sample property. We have also provided a blank Income Property Cash Flow Worksheet for your use. SQUARE FOOTAGE For an accurate calculation of property rent potential and comparison of the subject property with other buildings, the appraiser determines the property square footage in various terms: Gross square feet: The total amount of space in the property. This can include common areas, stairwells, elevator shafts, utility closets, corridors, lobbies, restrooms, and even loading docks. Rentable square feet: How much space can actually be leased and will generate rent? A tenant will typically not pay directly for the space occupied by common areas, restrooms, etc., but may be allocated proportionate responsibility for these amenities. Usable Square Feet: The amount of space the tenant will actually be able to productively use for their business. The correlation between these square footage measures allows the appraiser to determine the overall efficiency of the property, which factors into the determination of rental rates which the property can achieve. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral 2. Analyze contract rents in place and/or estimation of market rent to determine appropriate rental rates for the property. Multiply this rental rate by the appropriate square footage measure to calculate property’s gross potential income (GPI). DIMENSION 5 - 46 NOTES: RENT ANALYSIS The appraiser researches rental rates of comparable properties. The rental rates are analyzed based on the characteristics of the property, such as location, design, access, overall quality and condition, age, and lease terms. The appraiser makes any adjustments to the rental rates of comparable properties deemed appropriate based on differences in these characteristics. Also, within the subject property different rent rates will be assigned based on the desirability of the space; a basement suite or an interior corner in a retail center would typically warrant a lower rental rate. Adjustments are made for these considerations as well. The total rents for the property are referred to as the gross potential income (GPI). They are expressed in annualized terms and reflect both the rents from existing leases and the potential rent for future leases on space, which is currently vacant. This allows the appraiser to determine a value for the property, and assumes it is no longer in a state of flux, i.e., in the midst of lease-up. This prospective condition or status is called stabilized occupancy. When analyzing rents, the appraiser will work to establish an effective rent for the property. An effective rent reflects the economic rent being paid for the space. Consideration and analysis of effective rents is necessary because the contract rent (the rent stated in the lease) is a function of tenant-landlord negotiation and, quite often, concessions. These concessions allow the tenant to pay less for the space in real economic terms. For example, the lease may include free rent for a period of time, or cover a tenant’s moving expenses. Omission of effective rent analysis can dramatically overstate GPI and wildly distort the property valuation. CRC US Body of Knowledge VACANCY ANALYSIS Logic says that there will always be some portion of the building that is not rented because it is between tenants, under renovation, or because of some other temporary reason. Additionally, rent collection may be an issue, particularly in multi-tenanted properties. The general convention is to express these factors as a percentage of total rentable square feet. In establishing a relevant vacancy rate for a property, the appraiser considers vacancy rates for properties similar to the subject property, and in the market overall while taking into account overall economic trends. The vacancy factor is applied to the property’s gross potential income (GPI) and then netted from the GPI to calculate the property’s effective gross income (EGI). DIMENSION 5 - 47 Operating expenses are expressed on an annual basis per square foot or in percentage terms. If a percentage is used, that percentage is applied to the EGI. These expenses include utilities, taxes, management fees, maintenance, marketing, insurance, and legal and accounting fees, etc. Note: these expenses are relatively fixed. They are the ongoing costs of property ownership. If the rents fall by 20%, the property operating expenses will not necessarily reduce by a like amount. Likewise if rents escalate, expenses may not follow suit. It is important to consider this directly in valuing and underwriting real property loans. Depending on how the lease is written, some operating expenses may be passed on to the tenant. In a gross lease, the building owner pays all expenses. Because of expense uncertainties, a gross lease will usually have a cushion built into the lease rate. A net lease passes some or all of the expenses on to the tenant. The most common type of net lease passes taxes, insurance, and maintenance expenses on to the tenants. This is typically called a triple net or NNN lease. The appraiser will carefully review the expense sharing arrangement in the subject and comparable leases to accurately measure the net expense burden to the property owner. RESERVE FOR REPLACEMENT EXPENSES This is a provision for normal wear and tear requirements of a property. It will cover such things as resurfacing the parking lot, replacing the roof, repairing the heating or air conditioning, and painting. In an apartment property it will include the cost of eventual replacement of dishwashers, refrigerators, carpets, and ranges. Note: the allocation of a reserve in the appraiser’s calculation does not guarantee that actual dollars are being set aside for these purposes. These expenses are expressed on an annual per square foot basis. NOTES: Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral OPERATING EXPENSES DIMENSION 5 - 48 NOTES: ROLLOVER EXPENSES This includes the cost of redecorating, renovation, and leasing agent commissions incurred when space is re-leased. These costs apply even if the space is re-leased to the existing tenant. These expenses are expressed on an annual per square foot basis. Rollover expenses can be very difficult to accurately quantify, particularly in a multi-tenanted property with irregular lease expirations. If this is the case, the appraiser will normally elect to complete the income capitalization approach using a discounted cash flow analysis. NET OPERATING INCOME Net operating income (NOI) is calculated by deducting the various property operating, reserve, and rollover expenses from the EGI as shown below on the Income Property Cash Flow Worksheet. NOI is an estimate of the property’s potential pretax, un-levered cash flow if leased in accordance with its own attributes and current market conditions. This is also referred to as the property’s stabilized NOI. In commercial banking terms this is conceptually the same as recurring EBITDA (earnings before interest, taxes, depreciation, and amortization). CAPITALIZING THE NOI CRC US Body of Knowledge The final step in determining the value in the income capitalization approach requires the application of a capitalization rate (cap rate) to the NOI. The cap rate is an estimated market driven rate of return which correlates to the risk profile of the property, among other things. The NOI is divided by the cap rate to calculate the value under the income capitalization approach. This is sometimes referred to as the value upon stabilized occupancy. DIMENSION 5 - 49 BLANK INCOME PROPERTY CASH FLOW WORKSHEET BUILDING TYPE ____________________________________________ Square feet __________________ x Revenues/square foot $__________________ GROSS POTENTIAL INCOME $_________________________ _____________________ %__________________ (______________________ ) EFFECTIVE GROSS INCOME $_________________________ _____________________ EXPENSES Operating expenses/square foot B $__________________ Reserve for replacement/square foot C __________________ Rollover expenses/square foot D __________________ Total expenses/square foot $__________________ x Total square feet NET OPERATING INCOME (N.O.I.) $ ( _____________________ ) _______________________ (Income available for debt service) VALUATION ESTIMATE Capitalization rate E Estimated value = N.O.I. ÷ Cap rate % _________________ $ A Average annual vacant space, expressed as a percent of total square feet. B Expenses such as utilities, taxes, management fees, maintenance, marketing, insurance, legal, and accounting, etc. Expressed on an annual basis. C Estimate of this year’s expense contribution toward future capital expenditures such as appliances, heating/cooling units, roof, and parking surfaces. D Expenses incurred to attract new or renewal tenants, such as redecorating, renovation, or reconfiguration of the space. E Blended rate that reflects market interest rates, risk levels for this property type, and the return investors want to see on instruments with similar risk characteristics. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Less: vacancy % A DIMENSION 5 - 50 INCOME PROPERTY CASH FLOW WORKSHEET SAMPLE FOR ACTION LEGAL CLINIC BUILDING TYPE Office ____________________________________________ Square feet 20,000 __________________ x Revenues/square foot $24.00 __________________ GROSS POTENTIAL INCOME ______________________ $480,000 $_ _______________________ Less: vacancy % A _________________ 15% 72,000 ) (______________________ EFFECTIVE GROSS INCOME ______________________ 408,000 $_ _______________________ EXPENSES Operating expenses/square foot B __________________ $6.00 Reserve for replacement/square foot C __________________.15 Rollover expenses/square foot D __________________.60 Total expenses/square foot __________________ $6.75 x Total square feet 135,000 ) ( _____________________ NET OPERATING INCOME (N.O.I.) _______________________ $273,000 (Income available for debt service) CRC US Body of Knowledge VALUATION ESTIMATE Capitalization rate E ________________ 10.5 % Estimated value = N.O.I. ÷ Cap rate $2,600,000 _______________________ DIMENSION 5 - 51 TIPS FOR REVIEWING THE INCOME CAPITALIZATION APPROACH NOTES: Carefully review the description and location of each comparable property to determine if it is truly comparable to the subject property. Examine all adjustment to see that they are reasonable, well supported, and consistent. The rents and vacancy rates selected by the appraiser should be well supported by market evidence and the existing or anticipated operating expenses of the building should be compared with those of similar properties and/or to general industry expense figures. Review the assumptions used in assigning the capitalization rate. If the appraiser has analyzed overall rates (OARs, the capitalization rates extracted from market transactions) from similar properties, the final capitalization rate should be in the same general range. If the appraiser feels that other factors (e.g., interest rate volatility, differences in risk levels due to location or owner-occupancy, etc.) will cause the capitalization rate to be out of line with the comparable’s OAR, these other factors should be discussed and supported. CAPITALIZATION RATES CONCEPT AND DYNAMICS OF CAPITALIZATION RATES The capitalization rate (cap rate) is the vehicle used to quantify the value of a property’s cash flows. It reflects the return investors want to see on instruments with similar risk characteristics, and represents a return on and of capital. It is a blended rate. Mathematically, the capitalization rate is: The rate at which a stream of periodic payments converts to a fixed amount of capital. It is expressed as a percentage and is intended to represent overall returns expected by investors from a particular property. When divided into a property NOI, the cap rate will provide a value estimate. Alternatively the cap rate can be determined (extrapolated) by dividing the cash flow stream of an asset (e.g., NOI) by its purchase price. Dimension 5 // Evaluate Collateral Values and Conduct Periodic Inspections of Collateral Focus on the timing of each comparable and verify that older transactions have been appropriately discounted in the weighting for that factor. DIMENSION 5 - 52 NOTES: Here’s a look at the basic concept using two simple examples. SCENARIO A You estimate a property, or any other investment, will generate $10M per year on a fairly reliable basis. The asset is being offered at a price of $100M. If you pay full price for this asset, you are implying that the risk profile of the asset (investment) should entitle you to a 10% return on the dollars you have invested. The 10% is the capitalization rate. SCENARIO B Alternatively, you determine that you are only willing to pay $83M for the same asset. This implies that you are requiring a higher rate of return on your invested dollars. This could be because you perceive the risk associated with the cash flow stream is h

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