Saturday, June 25, 2022

October 2005 Legal Briefs

Important Issues in Establishing Tragedy Accounts

  1. Using a Real Payee
  2. Endorsement Risk
  3. Tragedy Victim as Owner?
  4. Tax-Deductible Entity
  5. Setting up a Trust
  6. UTMA Account
  7. Risk-Based Approach
  8. Bank-Sponsored Account

Guidelines for Residential Tract Development Loans

  1. Appraisal Methods           
  2. Appraising Lots to be Developed       
  3. Loan-to-Value Ratios          
  4. Single-Unit Construction Loans       
  5. Substituting/Releasing Collateral   
  6. What is the Loan Amount?
  7. Commitment Duration
  8. Developing Too Many Lots
  9. Loans Exceeding LTV Ratios
  10. L.O.C. Borrowing Base

Important Issues in Establishing Tragedy Accounts

Destruction from Hurricane Katrina motivated many people to want to help.  Organizations and individuals collected not only food and clothing, but also cash, to aid the victims. As many as 13,000 hurricane-related evacuees are now living in Oklahoma, so the needs continue.  People are continuing to set up “tragedy accounts” to deal with the after-effects of the hurricanes.  

There’s nothing new about banks being asked to set up tragedy accounts, but such requests always increase when a major incident occurs.  (This was certainly true after the Oklahoma City bombing, and after the Oklahoma City-area tornadoes.)

From time to time, a tragedy happens in a local community, causing a major financial need, and people want to provide assistance.  A house burns down, the family loses everything, and there’s no insurance.  A young person dies in a car wreck and relatives can’t pay for the funeral.  Maybe a local firefighter or police officer is killed in the line of duty, leaving a spouse and young children in bad financial circumstances.  Perhaps someone wants to set up a scholarship fund to help with the children’s future college expenses.  A teacher or civic leader dies and people want to raise money for a memorial project. Or someone without medical insurance is seriously burned, or has cancer, or needs a heart transplant or kidney transplant, and the expenses are large.

In a variety of cases, someone comes to the bank and wants to set up an account to deposit funds raised for the particular purpose.  Maybe they want to set up the “Hurricane Katrina Disaster Fund.” Or, more locally,  maybe it’s the “Bobby Smith Medical Fund”—to help Bobby, who was in a bad car wreck and is unconscious; or he’s a firefighter who was badly burned.

In all such situations, my first choice would be for the individual(s) to arrange to raise funds under the name of some already-existing charitable entity, such as a church.  (The donation checks should be made out to the name of the entity.)  

There are several advantages to this approach:  (1) the donors get a tax deduction; (2) there won’t be any endorsement problems if the charity (rather than a made-up “fund”) is the payee; (3) the charity will handle the money responsibly; and (4) the charity will have procedures for replacing board members and officers, so that someone will always be available to act on the account.

When it’s hard to avoid putting one or more individuals in charge of a tragedy fund (instead of using a charity), there are other issues a bank should consider carefully: (1) Is there a logical connection between the individual(s) on the account and the stated purpose of the fund? (2) If the person who has the tragedy is alive, has he given his permission for persons to raise and deposit funds in his name? (3) How will any excess money be spent if it is not all needed for the intended purpose?  (4) Who will take over the account (and how) if the named individual(s) become unable to act?  (5) Would the bank feel more comfortable in collecting and disbursing the money itself—for example, to pay for a funeral?

Tragedy accounts raise many potential issues and problems.  When a bank is asked to set up one of these accounts, it should consider a variety of steps (discussed below) that can help to reduce the bank’s potential liability. 

1. Using a Real Payee

Every account opened by a bank must have both (a) an owner and (b) a taxpayer identification number matching that owner’s name.  With any tragedy account, a bank should style the account in the real accountholder’s name and TIN.  No legal entity exists with the name, “Hurricane Katrina Disaster Fund”—even if someone comes into the bank with twenty checks made out to that payee.  

Let’s say, for example, the owners of XYZ Manufacturing, Inc., want to set up a “Hurricane Katrina Disaster Fund.”  The account must be styled with XYZ Manufacturing, Inc. as accountholder, using its TIN.  With the business name on the first line, it might be acceptable to put “Hurricane Katrina Disaster Fund” on the second line.  This is sort of a sub-account, similar to “XYZ Manufacturing, Inc.–Payroll Account.”
In this example, checks should be made payable to XYZ Manufacturing, Inc., and not to the disaster fund (which does not legally exist.)  However, putting “Hurricane Katrina Disaster Fund” on the memo line of the checks is fine.

Maybe the people from XYZ say, “Not as many people will contribute, if XYZ is the payee on the check.”  In effect, they are really saying, “People wouldn’t write the checks if they knew the checks were going into the company’s account.”  This situation should bother a bank, because the company wants donors to remain somewhat uninformed.

In a more extreme example, what if it’s an individual, Sam Jones, who is trying to set up the “Hurricane Katrina Disaster Fund,” instead of XYZ?  This account should be styled in the name of Sam Jones.  The bank should require that checks deposited to the account be payable to Sam Jones.

(Contributors should be aware who’s going to deposit the money.  The bank should be alert to whether the circumstances will create an opportunity for (1) fraud, (2) misunderstanding, or (3) “reputation risk” to the bank.  For example, when the Category 5 tornado went through Oklahoma City several years ago, one person solicited checks for the American Red Cross, then allegedly tried to open a bank account under his own name, d/b/a American Red Cross, for depositing the checks. Obviously, a bank needs to stay away from situations like this.)

2.  Endorsement Risk

A depository bank gives an automatic warranty that is it transferring or presenting checks on behalf of someone entitled to enforce them.  This is a warranty against bad endorsements. Checks can be returned “breach of warranty” for up to three years, if the real payee does not get the money.

If checks are made out to “Hurricane Katrina Disaster Fund,” and there’s no real entity by that name, how do those checks get deposited to the account of  XYZ  Manufacturing, Inc., or the account of Sam Jones (my two examples above)?  The problem is, if there’s no real legal entity with the name “Hurricane Katrina Disaster Fund,” there’s also no one with authority to endorse checks made out to that payee.  Ideally, the bank wouldn’t want to take any checks made out to a “nonexistent” charitable payee like this.

It really doesn’t help to style the account as “XYZ Manufacturing, Inc., for Hurricane Katrina Disaster Fund,” or “Sam Jones for Hurricane Katrina Disaster Fund.”  Both of these imply that the real accountholder is an “agent” for the fund; but unless the disaster fund exists as a legal entity, it’s impossible for the accountholder to be appointed agent for the fund.  No one can give authority on behalf of an entity that doesn’t exist, so this approach provides no solution to the endorsement problem.

You might say, “Well, it’s the same endorsement issue that exists with a d.b.a. name for a business.”  (Checks are made out to “Joe’s Hardware,” but there’s no legal entity by that name.  It’s a sole proprietorship, with Joe Johnson as accountholder.)  But there are some important differences with a sole proprietorship.  The individual signs a “sole proprietor affidavit,” swearing that he (1) owns the business called “Joe’s Hardware,” and (2) has exclusive right to use the name.  If you also know that he is the same person who has operated in the community for several years under that name, his statements form a logical “bridge” that makes you comfortable with allowing him to endorse and deposit checks made out to that name.

If a check is made out to “Joe’s Hardware,” a bank is reasonable in assuming that the writer of the check (1) actually got some merchandise in exchange for his check, and (2) did intend to pay the hardware store, not someone else for some other purpose.  The bank’s main concern with business d.b.a. checks is just to be reasonably certain that there isn’t another business called “Joe’s Hardware” that may have had its checks stolen by the person trying to open the account at the bank.

When a check is payable to “Hurricane Katrina Disaster Fund,” a depository bank has no idea what was said to the person who wrote the check. He obviously was trying to make a donation.  If the money gets diverted (and doesn’t go to charitable purposes related to Hurricane Katrina victims), the writer of the check may start yelling “fraud.” When the community learns that an individual has misspent thousands of dollars after depositing “donation” checks at the bank, the bank may feel compelled to refund the donors’ money to avoid public relations or legal problems.  With any tragedy account the bank should satisfy itself that both the person and the project are legitimate.  If the bank has any concerns in the situation, it should probably say “no.”

3.  Tragedy Victim as Owner?

My second example mentioned earlier, the “Bobby Smith Medical Fund,” raises some additional issues.  Let’s assume that Bobby Smith is in bad shape, but still alive.  People are soliciting funds payable to this fund, and now they want to set up an account at the bank.  Whose name and TIN do you use on the account?

It may seem logical to set up a tragedy account in the injured person’s own name, if he is still alive (although this approach obviously won’t work in  raising funeral expenses for someone who is deceased).  At first glance it sounds logical to put the account in the person’s own name, because the money is for his benefit. (If any interest is earned, this styling would cause the interest to be reported directly to him, which also sounds logical.)

However, there are potential pitfalls in setting up the account in the victim’s name.  For example, if he is too ill to take any action, there is no way to legally authorize opening an account in his own name–unless a guardian has been appointed, or there is a power of attorney.  (If he were conscious, he could give his consent.)

Let’s say Bobby’s mother and sister come in and want to set up the “Bobby Smith Medical Fund,” and both of them want to be signers. They also want to endorse the checks that are made out this way.  (This is a technical problem because no actual “fund” exists, so no one can endorse for it.)  

Let’s assume that Bobby also has a wife, but the mother and sister don’t want the wife to be able to get at the money.  Although the money will be raised in Bobby’s name, Bobby is too ill to be aware of this (or consent to it), and Bobby’s wife (who will be his heir if he dies) is (for now) cut out of having access to the money.  Maybe everything will work out fine if the mother and sister spend the money to pay Bobby’s medical bills, but the bank could be in the middle of a lawsuit if the relatives start fighting.  

For example, if the account is set up in Bobby’s name, with the mother and sister as signers, the control of the account would probably pass to his estate at his death.  At that point the estate (or the wife) would be fighting to get the money.  Alternatively, if the account is set up as a joint account between mother and sister, but “for” Bobby, the unhappy wife (or Bobby’s estate) might sue because the mother and sister have “wrongfully” taken the money that was raised in Bobby’s name, without depositing it to Bobby’s account or actually having any legal right to act “for” Bobby.

An additional complication arises if there are some outstanding tax liens or judgments against Bobby.  Although the money was raised for “medical expenses,” it’s still not someone else’s money (if it’s set up in Bobby’s name).  The IRS or a judgment creditor might be able to reach any account that belongs to Bobby.  

A different problem exists if the money was set up as a joint account between the mother and the sister.  A garnishment on either of them would be very messy for the bank to deal with, because of the account’s loose styling.

An additional issue arises when something happens to the signer(s) on the tragedy account.  A bank should probably never set up an individual as signer on such an account, unless it also gets written directions with respect to (1) how someone else can take over the account if the signer becomes incapacitated or dies, and (2) what should be done with the money if the original purpose cannot be carried out—for example, if the money raised to pay for medical bills exceeds the person’s expenses incurred before he dies.  

To avoid many of the problems just mentioned, it is much better to set up a tragedy fund under a local organization, such as the First Baptist Church, or the Chamber of Commerce.  The account can be set up in the name of that already-existing entity, and the entity’s TIN can be used.  The bank should insist that all funds solicited from donors will be made out to the organization as payee.  Of course, “Bobby Smith medical fund” can be placed on the memo line of the checks.

As long as the money is raised in the name of a real organization, rather than in the name of the individual, the organization will have full authority to control the money, and the bank won’t get into legal problems with squabbling relatives, IRS liens, garnishments, etc.

I am reasonably comfortable when a local organization is raising and controlling the funds, because the First Baptist Church or the Chamber of Commerce will not likely misapply the funds.  Other possible choices are the Rotary Club, the Kiwanis Club, etc.

An additional advantage of using this type of entity is that there will always be board members and officers in place to run the organization, and if someone in charge dies or becomes incapacitated, it’s only a temporary problem.  The organization’s regular procedures will be followed to replace that person with someone else who will then be fully authorized to act.

4.  Tax-Deductible Entity

If people are trying to raise contributions to help with some “tragedy,” they ought to do so through a charitable organization whenever possible.  (If the donations are “tax deductible,” donors will tend to give more money.)  This seems so “logical,” but often it is not what people do. The persons raising money usually don’t want to go to the special effort to get the details right.  Also they usually want to control the contributed money themselves.  So they’re not focused on “what’s best for donors.”  

Often, donors assume (or are misled into believing) that their contributions to a tragedy fund are tax-deductible, when they are not.  Not only the depositor, but also many of the donors, will be the bank’s customers, so the bank is helping everyone, and protecting its own reputation, when it suggests that it would be better to set up a tragedy account under a local charitable organization, such as a church.

(In the examples given earlier, I mentioned the Chamber of Commerce and civic clubs as possible organizations to control the donations.  These are not tax-deductible entities, but still are acceptable choices from the bank’s standpoint, instead of letting individuals control a tragedy account by themselves.)

5.  Setting up a Trust

Almost everyone who sets up a tragedy fund will tell you that he doesn’t want to spend extra money or go to special trouble to set things up in a certain way.  He “just wants to keep it simple.”  (But the looser the individual wants to keep it, the more the bank may risk getting into the middle of future problems.)

Trusts can be created for a variety of purposes, including benefiting or honoring someone who is the victim of a tragedy—for example, to pay for the medical expenses of a person who is badly injured or needs an expensive operation; for the future education of young children; or to establish a scholarship fund in memory of a beloved local person who has died.

There is a sample form of trust, set out in Section 3010 of the Oklahoma Banking Code, that can be created in support of someone who is in need of help for various reasons.

There are advantages in setting up a formal trust, because it is a legal entity, and a bank account can be set up in its name.  It will have its own TIN (because it must obtain one).  Certain persons will be appointed as trustees, and will have a fiduciary duty in managing and spending the funds in the trust. (A bank can be named as the trustee, if it has trust powers.)  The trust will state what the funds shall be spent for. As with any trust, there are ways of putting a successor trustee in place if something happens to the original trustee(s).  All of these features are attractive for a bank, compared to a “loose” tragedy account controlled by individuals, with few or no instructions, restrictions, etc.

The sample trust form in the Banking Code is pretty straightforward, but persons setting one up should still ask an attorney to prepare it.  After the trust is created and obtains a TIN, it will have to file tax returns.  So there are going to be some expenses for an attorney and an accountant.  This will turn some people off—but logically they shouldn’t oppose doing things in the right way, if they want to do it at all.

6. UTMA Account

A UTMA account is a very workable solution to the “tragedy account” problem, if the person to be helped is a minor.  For example, when a minor has severe injuries or major illness, money can be put into a UTMA, with a custodian appointed to spend the money for the child’s benefit. (The Oklahoma Statues provide that money legally belonging to a child can be put into such an arrangement.)

As another example, if local residents want to raise money for the future educational expenses of the children of a deceased firefighter or policeman, the UTMA can be used.  Of course, if there are several children, each must have his/her own share of funds placed in a separate UTMA, because there can be only one minor per UTMA.

7.  Risk-Based Approach

In deciding whether to allow tragedy accounts to be set up for various reasons, a bank needs to evaluate the circumstances.  If an account will exist only for a fairly short time and for a limited purpose (such as raising funeral expenses), the account will be easy to monitor and probably will not involve much risk for the bank. If money is specifically raised to pay funeral bills, everyone will know what they’re contributing to. Because of the short time period, there’s not much likelihood that funeral money will be misspent before it is paid to the funeral home.  No one is likely to complain.

By contrast, if the deceased policeman’s three children are under the age of five, and money will be raised for their future college expenses (and put in a tragedy account but not a UTMA), there could be substantial money in the account, and it will be held for a very long time.  The larger the funds and the longer they will be on deposit, the greater the temptation may be for someone to misapply the money, and the bank may not be monitoring it.  The facts of the particular case should be considered in deciding whether to open an account (the specific persons, the purpose, the amount, the duration, etc.).

8.  Bank-Sponsored Account

Sometimes, because of the circumstances, the bank cannot really say “no” to some kind of tragedy account. But as the lesser of two evils, a bank may prefer to manage the account itself, rather than allowing the particular individuals to run it.  For example, where funds are being raised for a funeral, the bank could set up a fund, instruct people to make checks payable to the bank, and put “Smith Funeral Expenses” on the memo line. The bank then would collect and disburse the funds, assuring that the money will be spent correctly.  (From a public relations standpoint, the bank sees that it needs to do something in the circumstances, and it decides it would be more comfortable maintaining control itself, rather than turning control over to the persons that otherwise would want control of the money.)

Guidelines for Residential Tract Development Loans

On September 8 the federal banking regulatory agencies jointly issued “frequently asked questions” (FAQ’s) relating to appraisal and real estate lending requirements for “residential tract developments.”

A “residential tract development” is an overall project involving five or more units.  It includes developing raw land into five or more residential lots. It also applies to a construction loan to build five or more condominium units, or a builder’s construction line of credit for five or more homes.

These FAQ’s emphasize that in many ways it’s a more complicated venture to construct five or more residential lots from raw land, or to build five or more homes or condos, than it is to develop a single lot or a single residence.  For example, repayment of a “residential tract development” loan depends on locating five or more separate buyers, not just one.

With a “residential tract development” loan, the borrower’s right to obtain loan advances for continuing construction may depend on the stage of construction progress for several separate units–all part of the same loan but at different percentages of completion.  As construction progresses, the lender must do more careful monitoring, and must apply a more complex formula for determining loan-to-value ratios.  The regulators expect a stricter methodology.

I will discuss some of the FAQ’s and related real estate lending guidelines.

1.  Appraisal Methods

An appraisal for a “residential tract development” must reflect deductions and discounts for (1) holding costs, (2) marketing costs, and (3) entrepreneurial profit.  Repayment of this type of loan is specifically focused on sale of the collateral.  With multiple units, it’s appropriate to be more technical about specific valuation deductions and discounts to reflect what will be required to complete the project and sell the collateral.

The appraisal on such a project must adjust for (1) the presumed interest costs and other expenses of carrying a unit (a lot, a condo, a house, etc.) until it sells, (2) the anticipated realtor’s commission required for sale (or internal sales costs), and (3) the amount that the developer will need to retain from the sales proceeds to pay himself.

However, any units that are pre-sold may be excluded in determining whether the project must be appraised as a “residential tract development” of five or more units.  A unit is pre-sold if a buyer has entered into a legally binding sales contract.  (The developer’s lender should look at the sales contract and also verify that a buyer is pre-qualified or has permanent financing.)

2.  Appraising Lots to be Developed

When a bank is financing raw land for development into five or more lots, a similar appraisal process must be used.   To determine what the developed lots will be worth for collateral purposes (when completed), appropriate deductions and discounts should be taken from the anticipated sales price–costs of carrying the lots until sold, marketing costs, and the developer’s “profit” share.  

Any appraisal of raw land as if it were developed into five or more lots should include reasonable assumptions about the required period for selling the lots when they are completed. The appraisal should include a feasibility study or market analysis supporting the assumed time period.  If this absorption period is long, only part of the project should be appraised as developed lots, and the rest should be valued as raw land.

3.  Loan-to-Value Ratios

Maximum loan-to-value (LTV) ratios are as follows:  up to 65% of the value of raw land held for future development; 75% of the value of finished lots or 75% of the estimated market value of lots being developed; 80% of the value for multifamily residential construction; and 85% of the value of 1-to-4 family residential construction.

These ratios are not new, but the FAQ’s make clearer what “value” the ratios should be applied to.  As explained above, for a project of five or more units, “value” should net out the required “deductions and discounts.” Also, for loans to purchase land or finished lots, the collateral “value” cannot exceed the acquisition cost, even if appraised market value increases. 

4. Single-Unit Construction Loans

It is fairly common for banks to finance a developer’s construction on an individual unit basis.  Although a builder is constructing several spec homes at the same time, the bank may be financing each unit separately. This apparently doesn’t meet the definition of “residential tract development,” because the homes are not treated as pieces of a larger project, nor are they part of a single construction line of credit.   

If the lender finances the construction of each unit separately, and obtains an appraisal of each unit separately, is the appraisal required to use the “deductions and discounts” approach?  Apparently not.  At first glance, if the “value” of the bank’s collateral does not have to be reduced by these adjustments, the “loan-to-value” maximum on a single-unit loan might be a little higher than if the same unit were part of a “residential tract development,” with the value reduced by “deductions and discounts.”

The FAQ’s do warn that if a bank relies on the individual unit approach–determining “value” based on an appraisal with no “deductions and discounts”–the bank will need supporting documentation to demonstrate that the unit(s) collateralizing the loan are likely to be constructed and sold within 12 months.  

Similar to the “residential tract development,” the bank still needs some kind of feasibility analysis or market study (not provided by the borrower or the bank’s loan officer), to support a conclusion that a 12-month period for construction and sale of the unit is realistic.  

An appraiser’s standard definition of “market value” included in an appraisal should assume a sale at the stated price within a reasonable time.  Just the normal “boilerplate” in the appraisal may be enough (but read it to be sure)—or the lender can ask the appraiser to address the point more directly by adding a sentence or two concerning the likely period required for construction and sale.  

In addition, for loan-to-value purposes, the FAQ’s require a bank to treat a unit’s collateral value as the lower of (1) the market value of the collateral or (2) the borrower’s actual development and construction costs.  For example, if an appraisal suggests that a home, when constructed, will have a $130,000 market value, and the builder’s actual development and construction cost will be $110,000 (not including  sales commission, builder’s profit, etc.), the bank must calculate the “loan-to-value ratio” based on the construction costs, if less than the final market value.

To summarize, a bank is not required to order a more complicated appraisal for a single-unit loan (one that makes “deductions and discounts”), but the outcome may be roughly the same, because what the bank uses as “value” for LTV purposes cannot exceed the development and construction costs.  Further, if it is not likely that the unit will be constructed and sold within 12 months, the bank apparently will need to adjust the value at least for the holding costs and marketing costs related to a longer time period—even though the appraisal on the single unit is not required to contain these adjustments. 

5.  Substituting/Releasing Collateral

Another interesting quirk of “residential tract development” loans (as stated in the FAQ’s) is that the loan-to-value ratio must be recalculated each time collateral is released or substituted.  The very nature of a “residential tract development” loan (involving five or more lots, five or more condos, etc.) is that individual units are expected to be sold at multiple times during the life of the loan.  (With a single-family construction loan, no sale of collateral occurs in the middle of the loan.)

Every time a developed lot or condo is sold and the net proceeds are applied to the loan balance, a bank must re-calculate the loan-to-value ratio for the loan–the remaining debt as a percentage of “value” of the remaining collateral.  With each release or substitution of collateral, the loan-to-value ratio still must remain within the maximum percentages allowed by regulation (stated earlier).

Each unit of a “residential tract development” that the bank releases as the result of a sale will normally provide a current indication of market value for the remaining units, if they are similar. Therefore, each sale provides an opportunity to reassess the value of each remaining unit that a bank holds as collateral.  

The pace at which individual units in the “residential tract development” are selling could also prompt a bank to re-examine its assumptions concerning the appropriate amount of “deductions and discounts” from the remaining collateral’s “market value.”  If it becomes apparent that a longer holding period before sale may be required, that conclusion logically may cause the bank to increase the amount of “deductions and discounts” (carrying costs and marketing costs subtracted from the eventual anticipated sales proceeds).

6.  What is the Loan Amount?

A bank’s “loan amount” is the total advanceable limit of the loan, line of credit or other legally binding commitment—not just the current balance.  It is the maximum amount that the bank would be committed to lend.  

Obviously, the “loan amount” could be vastly different if a bank commits in advance to finance completion of an entire multi-phase tract development project, instead of committing to finance only one phase of development at a time.

7. Commitment Duration

The guidelines tend to focus a lender on agreeing to finance only the portion of an overall project that can be completed and sold within a reasonable time, usually not exceeding twelve months.  If the developer’s overall development of five or more units (lots, condos, homes, etc.) will take more than twelve months to develop and sell, the required amount of “deductions and discounts” from the presumed sales price of the units will increase proportionately.  These adjustments reduce the “value per unit” on which the loan-to-value ratio and total loan commitment must be calculated.

In other words, what the developer can borrow “per unit” will decrease if the loan commitment extends for too long and allows the developer to build at once more units than can be sold in a reasonable time.  

Stated more positively, a developer can borrow somewhat more per unit if he works in phases, obtains separate commitments for each phase, and builds only what he can complete and sell fairly quickly—minimizing the deductions from value that are required because of anticipated carrying and sales costs.  (The rational developer will want to minimize these costs anyway; but a banker may need to “rein in” some developers who are overly optimistic about the market’s ability to absorb the units in a reasonable time.)

8.  Developing Too Many Lots

Potential problems in providing a loan commitment for a multi-year development project are increased if the financing is for the purpose of turning raw land into developed lots.  The rules for appraising lots to be developed from raw land are fairly punitive, if the appraisal is for development of more lots at once than the market can absorb in a reasonable time, such as twelve months.  

For example, a developer might think it would be efficient to completely develop a tract of raw land into finished lots, all at once—even if it may take three years to sell all of the lots.  The appraiser’s problem is that any lots that cannot be absorbed by the market in a reasonable time must be valued as raw land, even if they are actually going to be fully developed lots.  

So if a banker is asked to commit to lending enough money to develop 30 lots, and only 10 lots can be sold in one year, 20 of the lots will likely be appraised as if they remain raw land.  This approach limits the value of the banker’s collateral, on which the loan-to-value ratio must be calculated.  In this situation, the developer will not be able to borrow very much money against lots that he cannot sell in a reasonable time.  If the developer insists on developing all of the lots all at once, he can still do so, but only if he uses his own money—not the bank’s.

(This approach to valuation is intended to prevent a developer from over-extending himself by developing more lots than the market can absorb.  As a result, the developer will tend not to develop more lots than he can sell in a reasonable time, and the lender will avoid a situation of having to foreclose on a quantity of lots that cannot be sold in a reasonable time.)  

9. Loans Exceeding LTV Ratios

The regulators do allow banks to make a limited number of loans in excess of the supervisory loan-to-value percentages (as listed above), but this should be done only very selectively and “based on the support provided by other credit factors.”  Such loans (exceeding the LTV ratios) must be specifically flagged as such in a bank’s records, and must be reported to the board at least quarterly.

The aggregate total of all loans that are in excess of the supervisory LTV ratios should not exceed 100% of the bank’s total capital, and the aggregate of all loans that are not 1-to-4-family and that exceed the LTV ratios should not exceed 30% of the bank’s total capital.  “An institution will come under increased supervisory scrutiny as the total of such loans approaches these levels.”

As stated earlier, with a “residential tract development” loan it is necessary to recalculate the LTV ratio at each separate date when a unit is sold and released as collateral.  It is possible that a loan originated within LTV limits could later exceed the LTV limits—for example, if units have to be sold substantially cheaper than anticipated, causing the remaining debt to represent too large a percentage of the value of the remaining collateral.

The loan agreement probably should require the borrower to maintain the loan balance within the LTV maximum at all times—either by reducing debt or adding collateral that is acceptable to the bank.  It should be clear that the “value” on which the LTV is calculated must follow regulatory appraisal requirements.  In some cases, the ongoing requirement to satisfy the LTV ratio will override or cap the bank’s obligation to make additional advances. 

10.  L.O.C. Borrowing Base

A “borrowing base” is a concept often found in revolving lines of credit for residential tract developments.  It is basically a pre-determined formula for calculating the maximum amount that the bank would be willing to lend to a borrower at a specific time, based on the type and value of collateral that the bank is holding. A line of credit usually also has a maximum loan commitment amount or “cap” that will not be exceeded, although the borrowing base approach might qualify the borrower for a higher amount.

Typically, a borrowing base establishes different advance rates for each category of collateral pledged on the loan, such as raw land, developed lots, homes under construction, and completed but unsold homes.   The amount of collateral that a developer owns in each category will vary from time to time.  Multiplying the advance rates for each type of collateral by the appraisal value of each category yields a series of numbers that, when added together and compared to the outstanding loan balance, will determine how much in additional funds a borrower would be eligible to draw down at a particular time.  (The advance rate for a developed lot is generally a lower percentage of the lot’s value (reflecting higher risk), whereas there is a higher-percentage advance rate for a completed home, which is more readily saleable, representing less risk.)

Other eligibility provisions may be imposed by a lender.  For example, a bank can limit how many speculative units the developer is allowed to include in the borrowing base at one time.  A completed unit that has remained unsold for a certain time (although still pledged) can be excluded as eligible collateral in calculating the borrowing base.  Such provisions limit the developer’s ability to obtain further advances, if he is building units that either are too risky or are not appealing well to the market.  In this situation he has to sell what he has built, before he can build more. (And if he can’t sell what he has built, the lender will be glad to be able to cut him off before it gets worse.)

A borrowing base formula should be designed so that it requires a borrower to maintain appropriate levels of “hard equity” (either cash or sufficient equity in the underlying property), throughout the construction and marketing periods.  Requiring the borrower to maintain a “cushion” gives the bank some protection against the developer’s cost overruns, any unexpected holding and marketing expenses, and necessary reductions in sales price.