A loan officer's guide to real estate investor contingency analysis

RMA Journal, The, June, 2004 by Tim Lovelace

Contingency cash flow can be used to analyze the strength of support provided by a guarantor. Armed with additional insight into the underlying discretionary cash flow, lenders should be able to better assess a guarantor's true support.

Individual loans made to finance income properties with existing or projected cast flow streams share an all-too-common problem. Since the cash flow streams dictate the true value of the collateral, the secondary repayment source or liquidation of the property is closely tied to the primary source, if you lose the cash flow, the value of the property declines. As a result, the personal guarantees of the principals or investors are used to provide a tertiary repayment source. Assessing the true support of these guarantees is often difficult because most real estate investors have contingencies--either closely held companies or other solely or jointly owned projects--that also require their guarantees.

Community banks and region al banks often deal with investors who have a number of projects in small to medium-size communities. These investors typically do not pursue the nonrecourse or conduit markets because many of their projects have foxy, if any, credit tenants. When relying on such borrowers, it is important to thoroughly understand the underlying dynamics of their personal cash flow.

What Is Contingency Cash Flow?

Contingency cash flow (CCF) is a guarantor's (if the borrower is a corporation) or obligor's cash available to service contingent obligations. While this is a simple definition, figuring out the amount is more difficult. The loan officer must obtain detailed tax and financial information--often on a number of entities--and inquire into the specifics regarding partners, individual projects, and loan terms. While the goal may be determining the CCF, the process also provides valuable insight into the guarantor or obligor.

Why Bother?

Determining CCF takes time--time that could be spent making calls or attending to other pressing portfolio tasks. Why should a lender or analyst do this?

1. To avoid being, put on the defensive. Lenders who deal with loan committees and/or loan administrators know the embarrassment of having a loan request go downhill and the ensuing questions about the guarantors and their contingent obligations. Breaking down contingencies and analyzing them is difficult, so it's often easier to dismiss a request, rationalizing that the investor has "too many irons in the fire." A lender who knows exactly the investor's obligations and how they could impact personal cash flow is better prepared to defend a loan and to answer questions head on.

2. To find buried treasure. Because most contingent liabilities are bank loans, the lender may be able to discover an opportunity to refinance a loan currently with a competitor. It is almost a cliche in sales to say that the best business comes from existing customers. Think how much calling and prospecting time could be saved by locating just a few loans buried in the boring details of financial statements.

3. To document the file. With so much outside review of credit documents, the CCF is immensely helpful to examiners, internal loan review, and credit administration in documenting the due diligence of the lender. Most real estate investors' dealings are complex because they may be done individually, with partners, through limited-liability corporations, or through other corporate entities. The calculation of CCF helps to unwind some of the complexity.

Determining CCF

Figure 1 presents the CCF worksheet for Mr. R.E. Investor, a fictional bank customer. Figure 2 presents the selected tax return, financial statement, and other information used in the calculation of Mr. Investor's CCF.

The worksheet starts with the investor's most recent adjusted gross income (AGI), subtracts taxes, and then makes adjustments to factor out nonrecurring items. Further adjustments are made to add back interest and depreciation from asset and liabilities related to investments that have deficient cash flow. Care must be taken here to identify all direct and indirect liabilities. For this reason, the worksheet has three separate columns. The Properties column identifies interest and depreciation from solely held and jointly held properties. The Closely Held Companies column presents the investor's corporate and partnership interests, and the Schedule C column is for all interest and depreciation flowing through proprietorships. After all interest and depreciation are added back, the sum represents cash available for living expenses, personal debt, and contingent debt. Next, an allocation for living expenses and personal debt obligations is made. After all of the above items are subtracted, the result is CCF.

Adjusted gross income. The first step in the contingency analysis is to list all relevant personal tax-return data in a column. Start with AGI (line 33 on the personal tax return) at the top of the column. AGI is used because it is the most reliable indicator of true income. It may be more appropriate to use a three-year average, since many real estate investors have wide income swings year to year, depending on the stages of various projects. For example, a subdivision developer may incur expenses during a year when a subdivision is being developed but have income in the following years when lots are being sold. As you can see, Mr. Investor had $500,000 in AGI for 2002.