As member-owned financial cooperatives, credit unions are well familiar with the ins and outs of mortgage lending to families buying a home, including how to judge and reduce risk. But as the industry gets deeper into commercial lending, a growing number of credit unions are finding themselves engaged in an unfamiliar new type of calculus.
That’s because underwriting member business loans differs in some fundamental ways from providing a mortgage for a house or condo. While the opportunity to forge a profitable, long-term relationship that benefits both borrower and lender is the same, evaluating the property involved is a very different process.
That’s where services such as formal collateral reviews from third-party partners come into play. That expertise is part of the package of collateral solutions offered by Servion Commercial Loan Resources, which now serves more than 500 clients, including about 470 credit unions.
Tony Lillie, Chief Credit Officer, Servion Commercial Loan Resources
Here’s more about collateral review in the context of commercial lending, courtesy of Tony Lillie and Janet Nelson, chief credit officer and collateral solutions manager, respectively, for the commercial lending services arm of The Servion Group in New Brighton, MN.
What is collateral review and what role does it play in commercial lending?
Tony Lillie and Janet Nelson: Put simply, collateral review is the due diligence that a credit union – or any other lender – does to ensure the accuracy of an appraisal report on a commercial property that’s being used as collateral for a loan.
It can get complicated, but it comes down to something like this: The appraisal for a potential deal tells you that a property is worth $1 million. We review that report in detail using the Interagency Appraisal and Evaluation Guidelines (IAEG) to see if the data provided supports the conclusion.
How does a commercial appraisal differ from a residential appraisal?
TL/JN: The biggest difference is that appraisals on residential properties are primarily all about what comparable properties have sold for. For a home loan, you look at properties in the same neighborhood, the same size, same layout, roughly the same condition, all those factors that credit union mortgage lenders are very familiar with from years of lending to homeowners.
But in commercial transactions, cash flow is usually the driving force when you’re reviewing a property as the proposed collateral. A good example is a situation we had near our offices here in Minnesota. There were two apartment buildings, located on the same street and similar in size and age, which sold for different amounts. One was sold for $825,000 and the other for $680,000. The difference? One was locally owned, immaculately maintained, and 100% occupied. The other had an absentee owner, deferred-maintenance issues, and was only about 80% occupied. The difference in the income streams for these two properties was the primary contributor to the sales price variance.
How does effective collateral review help address risk for credit unions doing commercial lending?
TL/JN: Well, the risk arises because there are so many factors to consider that you just don’t see in a residential appraisal, including the types of businesses leasing the building, any potential environmental issues, and different regulatory rules covering everything from local zoning codes to federal agency oversight of sound lending practices.
Janet Nelson, Collateral Solutions Manager, Servion Commercial Loan Resources
The value of the property you’re underwriting is your credit union’s backstop, your last line of defense, against ultimately losing your investment in that owner and that property. That collateral would quite likely be the last thing liquidated to pay back the loan if a collection action got to that point.
The collateral review process helps create the final values that go into the appraisal, and it helps you, the lender, make sure the value is not overstated, that it’s not overly optimistic about what the borrower could get for the property if they had to sell it to satisfy creditors.
Please describe how collateral review is done. What are some of the most principal elements/procedures involved?
TL/JN: There are three big pieces to this process. First, there’s compliance. We ensure the collateral reports comply with established regulatory practices, including those from the IAEG, Uniform Standards of Professional Appraisal Practice (USPAP) and FIRREA.
The second part is we stress-test the data that the appraisers provided in their report. We want to ensure the data provided lends support to their final opinion of the value of the property. We take apart their report and put it back together again and see if we come to the same conclusion.
Thirdly, there’s due diligence about the appraisers themselves. Are they properly licensed? Are they properly insured? Have there been any disciplinary actions against them? We make sure the lender is aware of any potential issues.
Please describe the level of expertise needed to do an effective collateral review.
TL/JN: Collateral analysts these days must have deep knowledge of IAEG regulations which state: “The depth of the review should be sufficient to ensure that the methods, assumptions, data sources, and conclusions are reasonable, well-supported, and appropriate for the transaction, property, and market.” We evaluate this is by digging into the intricacies of the commercial appraisal report. After completing an initial checklist, we take that next step to gain a deeper understanding of what is in the appraisal report. How were the values computed? What is the reported cash flow and does it make sense? And so much more.
The whole premise behind this process is to make sure the collateral review is being done by people with experience. We’ve done thousands of these, and our team continues to gain more experience and insight every day.
How can my credit union find out more about Servion?
TL/JN: The easiest thing to do is visit our website at myservion.com. People can also find us on LinkedIn, Facebook, and Twitter. You can visit all those social media sites and search for The Servion Group to find us.