Evaluating collateral for asset-based lending opportunities
Collateral is a tangible asset that a borrower offers a lender to secure a loan. The lender’s claim to a borrower’s collateral is called a lien. If the borrower stops making loan payments, the lender can exercise the lien, seize the collateral and sell it. Equipment, buildings, real estate, accounts receivable and even can be used as collateral. Before making a loan, a loan originator evaluates the collateral a borrower is offering from several angles, including loan-to-value, liquidity and seniority, which we’ll explain below.
Italian bank Credito Emiliano has accepted giant wheels of Parmigiano-Reggiano cheese as collateral for small-business loans since 1953! Credito Emiliano’s cheese collateral is an example of using inventory as collateral. The bank stores and ages the cheese in climate-controlled vaults for the duration of each loan. The more the cheese ages, the more delicious–and valuable–the collateral becomes.
Loan-to-value: a ratio that clarifies risk
LTV is a ratio lenders use to evaluate collateral. The higher the LTV, the riskier a loan is for the lender. LTV is calculated with this simple formula:
Loan to Value = Loan Amount/Appraised Value of Collateral
LTV ratios of 80% and below indicate that a healthy amount of collateral is securing the loan. According to a Harvard Business School case on Credito Emiliano, the typical loan-to-value ratio for those cheese deals is 70 to 80 percent, which cushions the bank against price fluctuations in the cheese market.
The lower the LTV ratio, the more attractive a borrower is to a lender, and the lower interest rates the borrower will have to pay for a loan.
Let’s say Gerry wants to borrow $92,000 to purchase a $100,000 property. Since he plans to finance most of the purchase with debt, that puts his LTV ratio at 92%. Unfortunately for Gerry, he will probably not be able to get approval for this mortgage.
Loans with LTV ratios above 100% are considered “underwater,” because the collateral is worth less than the loan. When home prices tanked during the Great Recession, many people found themselves owning homes that were worth less than their mortgages. Their mortgages were “underwater” because their LTVs were over 100%.
Liquidity: how fast can collateral be turned into cash?
Yieldstreet originators also examine the liquidity of collateral. An asset that can be sold for cash within 24 hours is considered liquid. Other assets have varying degrees of liquidity. Land that has never been developed, for example, usually takes longer to sell than an office building full of rent-paying tenants. The office building would be considered a more liquid source of collateral than the raw land. Lenders prefer collateral to be as liquid as possible.
Seniority: who gets paid back first?
Finally, YS originators look at loan seniority, or the order in which borrowers get paid if a creditor fails to pay debts. In other words, if a borrower goes bankrupt and is forced to sell assets to pay his or creditors, which creditor gets paid first?
The creditor holding senior debt is giving priority in the event a debtor files for bankruptcy protection. This makes senior debt the least risky type of secured lending. Most Yieldstreet offerings are senior debt. Senior debt is typically backed by collateral that is reasonably liquid and has a low LTV.
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