What is collateral valuation?
Private lenders have four main tools they will use to determine collateral valuation: appraisal, broker price opinion, automated valuation model and personal research. These tools will consider multiple points of value to ensure the lender isn’t missing a crucial detail.
Lenders worth their salt will rely as much on their own research (which may even include visiting the property) as anything else that comes across their desk.
Anything you can do to show the lender that you’ve completed your own due diligence will go a long way toward proving that their money – or their private investor’s money – is safe with you. Still, when it comes to collateral valuation, keep in mind that even when considering the same factors, the lender may have a very different opinion of what’s acceptable based on their own experience and risk tolerance.
The multiple points of value in collateral valuation
Here are some factors not always included in a typical collateral valuation tool:
- Building permits
- Capital expenditures
- Environmental considerations
- Expenses and operating costs
- Floor plan and functionality
- Future zoning changes and area developments
- Location, location, location
- Market trends
- Parking availability
- Vacancy factor
This is how the property’s primary users will get to it. Properties on private streets can have access due to no local road maintenance (which includes things beyond potholes: think snowfall). A commercial property located amid residential structures may have issues with licensing if the business will require frequent semi truck deliveries, impacting potential lessees.
You will also want to be wary of land that is “locked” or does not have property easements as this will lower a property’s collateral valuation. Be sure the land has access to sewer, water, and utility hook-ups, or is able to have a septic system installed if a municipal hookup isn’t available.
If the previous owner completed unpermitted work, the structure may have to be dismantled depending on local codes. A correctly permitted construction project may require new or updated permits, causing costly project delays and lowering the property’s collateral valuation. Inspectors have been known to require entire buildings to be dismantled because materials have aged or codes have changed between project start to finish.
These will vary by property type and use, and define fixed (i.e., one-time-cost) assets that will be productive to the property for a long period of time. They may include appliances, carpet and roofing, large machinery and more.
Be wary of properties that have not had a Phase I, or if required, a Phase II environmental study to determine past uses of the property. Residential properties should be tested for mold, radon, and meth.
Expenses and Operating Costs
Verify that the expenses for the property are realistic, and you have factored a reasonable increase to these costs in the future. Unlike capital expenditures, these are expenses that relate to specific transactions and operating periods, such as the cost of goods sold, repairs and maintenance expenses (like trash service, utilities, etc.).
Floor Plan and Functionality
Whatever the property type, the layout should be practical for the intended or best use. For example, “chopped up” floor space in a commercial building (lots of small offices) that would require extensive remodeling to “open up” to attract tenants. Residentially, a spacious home on paper can be a nightmare to sell if it isn’t laid out in a manner that makes sense (especially in cases where the property has an extension or was custom-built).
Future Zoning Changes and Area Developments
Changes in the immediate area may have a positive or negative effect on value depending on what they are and how close they’ll be to the subject property. In most cases a typical appraisal will not include them. Check with the local zoning and planning office to find out about possible future changes that have been approved or are currently being proposed, such as large shopping center, residential areas and more. You will also want to check with the state Department of Transportation regarding roadways and construction.
The income projections must be realistic to ensure you accurately determine your net operating income for both the property and your business. This enables the lender to correctly determine the rental property’s value (usually a multiple of your net operating income) and appropriate debt coverage ratio. Many real estate investors speak with tenants personally or use index reports like RentFax. Providing reports like this to your lender as part of your justification for “why this property” will go a lon way toward assuring the lender you’ve done your due diligence.
Location, Location, Location
The exact same home will be worth a wildly different amount if it backs up to an oil change shop vs. another house. This detractor comes down to the individual property rather than the neighborhood (and why your grandma was always going on about their hoarder neighbor who didn’t mow their lawn).
Location also encompasses the availability of amenities within driving – and in some urban communities walking – distance. The best properties will inhabit a “just right” zone on the Goldilocks Quality Scale: close enough to amenities, but not too close.
Know what the trends are for the market, property type, layout and design. Are values stagnant, going up, or going down? Are there a lot of for-sale or for-lease signs on similar properties in similar areas, and if so, why?
This mainly impacts commercial loans, but a lack of parking spaces for customers, employees or tenants. This can include the kind of parking also: two properties may have the same number of spaces on paper, but one property has half of them as tandem spaces where one party is trapped in their space until the car behind it moves.
Residentially, a home located in an area (city, street or HOA) that doesn’t allow street parking will be worth less if the lot itself doesn’t accommodate for more than one vehicle.
You will need to know the local trend in vacancies, called the vacancy factor, for similar local properties. Index reports like RentFax will provide statistical analysis to give you this factor, which you can then pass onto the lender as assurance you’ve done your due diligence.