“Show Me the Equity!”

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I once sat down with a lender client and asked for an explanation of the lender’s underwriting process. My client looked at me, and after about a minute, he did his best Tom Cruise impersonation and yelled, “Show me the equity!”  If he thought a deal had sufficient equity, he would approve it. Likewise, if a deal lacked sufficient equity, it was declined. That leads to my next question: how did the lender determine a property’s value to calculate the amount of equity in a deal? At the time, I had just migrated over from almost exclusively representing national banks and other federally regulated financial institutions in real estate-secured financings. My worldview at the time consisted of banks engaging licensed appraisers to conduct a fully compliant FIRREA appraisal. No loan went forward without such an appraisal. These appraisals cost thousands of dollars and took up to 4 weeks to complete. The banks then took another 1-2 weeks to complete an internal review of the appraisal before finally settling upon a property valuation. There is no way this timeframe would work in the hard and fast-paced world of private lending.

It goes without saying that in the private money lending space, a few days can be the difference between moving forward with a transaction or a disaster. This statement is true of both lenders and borrowers.  Accordingly, private money valuations need to be reliable and expeditious to satisfy the competing interests of lenders and borrowers. Lenders need accurate valuations to base their underwriting upon and to price their loans accurately. Conversely, borrowers need quick property valuations that lenders can use to approve a loan, or the borrower may lose property to a competitor or fail to meet some other urgent deadline. 

The most well-known form of property valuation is an appraisal. Each real estate secured loan requires appraisals made by a federally regulated financial institution such as a bank or credit union.  With federal law imposing strict appraisal requirements, bank appraisals are the most comprehensive, time-consuming, and expensive form of property valuation. Appraisals can take up to 4 weeks to complete, with the average cost of a commercial appraisal ranging from $2,000 to more than $25,000 depending on the property appraised.

 It is difficult to fathom how a commercial appraisal can fit into the fast-paced world of private money lending when many deals need to close within a few days. However, this does not mean appraisals are never used by private lenders. Many private money loans start out as bank loans, and they become private money loans when the bank tells a borrower the loan has been declined or the bank cannot meet the borrower’s closing deadline. When this happens, a borrower will take their bank appraisal and approach a private money lender who is better situated to close the loan. In these cases, a private money lender would be more than happy to base its underwriting upon such an appraisal. Nevertheless, these cases are more of the exception rather than the rule.       

More often, private money loans are underwritten using an alternative form of property valuation.  One such method is a broker price opinion (BPO).  A BPO involves a licensed real estate broker’s professional opinion of a property’s value. A BPO can be an “internal BPO” or an “external BPO.” Both BPOs are conducted by a licensed real estate broker familiar with local real estate market conditions. An internal BPO involves a broker’s evaluation of a property’s condition by reviewing the inside and outside of the property. In this process, the broker will visit the property, take internal and external measurements, and even take pictures of the interior and exterior. In contrast, an external BPO, also referred to as a “drive-by BPO,” involves a broker simply reviewing the external condition of the property. In either case, the benefits of a BPO over a full appraisal are evident. A BPO can be completed in 3-4 days or less instead of the 3-4 weeks it may take to complete an appraisal. BPOs are also less expensive than appraisals, with the typical BPO costing $350-$450.

Another commonly used form of property valuation is comparative market analysis (CMA).  A CMA is similar to a BPO, and both involve valuations provided by a local real estate broker who is familiar with conditions in the local real estate market. Likewise, neither is performed by a licensed appraiser. A CMA will involve a broker reviewing “comps” of recent sales of comparable properties. The properties are comparable if they are the same type of property and are in the same area. In conducting a CMA, a broker will review the sales “comps” and make appropriate adjustments to the subject property based on the differences between the subject property and the recent comps. Some of the adjustments may be favorable to the subject property and increase the subject property’s value when compared to its comps.  For example, if the subject property was recently renovated and a comp needs renovation, the subject property will likely receive an upward adjustment in its valuation. The opposite is also true; If a comp was recently renovated and the subject property needs renovation, the subject property will likely receive a downward valuation adjustment. Though similar, a typical CMA will rely more on a recent sales date than a BPO. A CMA comes with the same benefits as a BPO compared to an appraisal. A CMA can be completed in a few days instead of 3-4 weeks, and CMA’s are less expensive than appraisals. Often, a CMA will be done for free by a listing broker or for the cost of a BPO.

Regardless of the method used to evaluate a property, determining a property’s value is key to a private money lender’s underwriting of a loan and its calculation of a loan’s loan-to-value ratio or LTV.  A loan’s LTV is determined by dividing the outstanding principal balance of the loan by the value of the property securing the loan. For example, a $250,000 loan secured by a property with a $1,000,000 valuation has an LTV of 25%. The lender has a 75% equity cushion to protect the lender against a loss if it had to sell the property, even at a discount, following a loan default. 

In short, the private money lending space is dominated by fast-moving transactions. This creates tension between a borrower’s need to move fast or risk losing property or failing to meet some other deadline and a private money lender’s need to have an accurate property valuation to determine a loan’s LTV.  In instances where a full-blown appraisal is not a feasible alternative, BPO’s and CMA’s offers can alleviate this tension and provide both borrowers and lenders an inexpensive, fast, and accurate method to value properties and facilitate transactions.            

For some California loans, when a licensed Department of Real Estate broker arranges the loan transaction, a true appraisal by a licensed appraiser may be required. California Business & Professions Code §10232.3 lays out specific LTV requirements for various property types and imposes additional underwriting and origination guidelines if there is a construction holdback and the broker is relying on the after-repaired value of the property to determine LTV. A helpful article outlining these requirements, including the use of a licensed USPAP appraiser, can be found here.

If you have any questions about property valuations and how they make affect your loan transaction, Geraci is here to help. Our team of experts has years of experience structuring transactions with their clients to make sure lenders are protected.

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