Collateral

Last month we discussed the second “C” of credit – Capacity and this month we’ll take a closer look at the third critical “C” – Collateral. Put simply, collateral is what you offer the bank as security over the loan you are applying for and could be a term deposit, a business (as security for a business expansion loan) or commercial or residential real estate, to name a few examples.

All of these represent potential collateral that you can offer your lender as security, in the unfortunate event that you cannot honour your repayments.

The type of collateral you present to the bank will dictate the lending percentage they will approve against that security for your new loan. This is known as the “Loan to Value Ratio” or LVR. Essentially, the lender will assess the security you are offering over the loan (generally by sending out an independent valuer to conduct a sworn valuation) to determine whether its value is sufficient to cover your required borrowings, as well as how easily they can liquidate (or release) it to recover their debt if necessary; the latter being of the most significance to the lender because let’s face it, that security is their only fall back option if you default on your loan and they need to recoup their loss.

When a valuer visits one of your properties to make their assessment, they are not just putting a price on it. Rather, there are a number of factors taken into consideration when they write their report to the lender, including;

• recent comparable sales that have occurred in the area,
• the likelihood of the value of your property reducing over a given time.
• the marketability of the property if a sale is required
• overall location and neighbourhood and how these factors could impact on resale
• a risk rating
• any environmental issues that could impact the value of your property over time

As you can see from the above list, the valuer’s assessment is largely seeking to determine how well the property offered as collateral would retain its value, along with its potential for resale over the long term. From the valuer’s report and depending on the property’s liquidity, the bank will determine its acceptability as sufficient collateral for the loan you are applying for. However a word of warning – not all lenders like all forms of security and many have certain preferences.

Because liquidity is really the key to the lender’s acceptance of any type of collateral over your loan, let’s consider this factor in more detail. The term deposit you offer as security would be able to secure a loan of equal value because it is highly liquid – in other words the funds can be released and secured by the lender relatively quickly. On the other hand, that small student accommodation you’re looking to buy and offering as collateral may only be able to support around 50% of the loan because it is perceived as a risky investment that could be difficult to resell given certain market conditions. All of this is about liquidity.

So how is liquidity determined? Here are some of the common factors considered by lenders when assessing the liquidity of the collateral on offer by loan applicants;

• How many comparable properties have sold in the last 3 months? In other words – is the area popular with buyers and therefore do properties move within a reasonable amount of time on the market?
• Can the market absorb the sale in a timely manner?
• Is this a common type of property for the area or is it an orphan that could take longer to move?
• Are there buyers willing to purchase this property?
• How might the local economy impact on the property’s resale potential? Eg. Regional areas that have only one industry propping up the local economy can be seen as carrying higher resale risk and less liquidity by the banks.
• Market segment conditions, ie. what segment of the market is this property in and how is that segment performing overall?
• What is the state of the market at the time of valuation – buoyant, balanced or declining?
• What is the predicted state of the market for the next 2 to 3 years?
• What other properties of a simular nature are coming up for sale? Ie. A large release of units in a CBD area?
• What condition is the property in? Does it need major repairs, is it tenantable, etc?

Collateral is one of the easier “C’s” to grasp because there are some general rules of thumb when it comes to determining loan to value ratios and it is quite a simple issue to discuss with your lender. Basically, all you have to ask of your bank is, “Do you lend against this type of security and if so what LVR would you borrow up to?”

So what are those general rules of thumb that the bank considers when it comes to collateral assessment? They include;

• Term Deposits – up to 100% equal loan to value ratio
• Median priced residential real estate – up to 95% LVR
• Fixed and floating charge over a franchise business – around 50 to 70% LVR
• Commercial office space with a tenant – up to 70% LVR
• Single student accommodation – around 50% LVR
• Speciality security like gymnasiums, caravan parks, service stations, hotels, rural holdings, vineyards and undeveloped vacant land is all assessed on a case by case scenario, but as general rule – maximum funding of around 50% LVR

With the radical shake up that has occurred within the lending market off the back of the global economic crisis and last year’s mortgage meltdown in the US, banks are undeniably beginning to reduce their appetite for risk and tighten their purse strings. As a result, we have recently seen a marked reduction in the types of security they will accept and a much more cautious assessment of collateral offered by finance applicants. An example of this is properties held in regional, single industry towns where the LVR has been reduced in many instances from 95% to 90% or sometimes even 80 to 85%.

The bottom line is; the more attractive, sellable and marketable and therefore the more liquid your collateral is, the more likely the bank is to say yes to a higher loan to value ratio and your overall application.

As I present each of these four critical “C’s” of Credit, you are probably beginning to realise that the initial 3 “C’s” – Character, Capacity and Collateral all play an important role in your loan application. Next month, I’m going to cover the final and fourth “C” of Capital. This is the one “C” that is the most negotiated within your loan application and if you are deficient in any of the other three “C’s”, Capital represents your bargaining chip to get the bank to buy your deal.

This entry was posted on Tuesday, October 27th, 2009 at 21:07 and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.