Author: Ted Boers, Datacomp Appraisal Services
Bio: Ted Boers is the founder of Datacomp Appraisal Services a company that specializes in mobile home values and valuation and operates MHVillage.com which is a website that specializes in the mobile home industry.

Does Collateral Matter?

Part II

During 1998 there were in excess of six hundred thousand sales of pre-owned manufactured homes. Approximately three hundred and fifty thousand of these homes were financed. Some of these homes were financed by lenders who were concerned about collateral value and some of these homes were financed by lenders who were not. This article describes the variety of collateral valuation methods used by today’s manufactured home lenders and the inherent risks associated with each of these methods and concludes with an assessment of how these various methods may impact the profitability of a lender’s manufactured home portfolio.

There are at least four different responses or methods, evidenced by today’s manufactured home lenders, to the question of how to best determine the collateral value of the pre-owned manufactured homes they finance.

The first response, exercised by some lenders, is to do nothing. This may work for small, local lenders who know their customers and are in effect comfortable with a signature loan, but is obviously dangerous for everyone else.

The second method is to “Book-It.” This is a fairly common approach which has the benefit of being fast but carries with it significant inherent risk. First we’ll define what we mean by the term “Book-It” and then we’ll discuss the inherent risk.

The lender who uses the “Book-It” approach buys one of the value guides that is available on the market. At the point of approving credit this lender would look in the book to determine what the home is worth.

For example:

Let’s say this lender is reviewing a loan application for a 1991 Redman Venture Villa, 28 x 56. He looks up this make, model, year and size in the book and determines that according to the book this home is worth $26,561.

At this point he is done. He just “booked it”!

Now let me explain why that is not a good way to determine the value of a manufactured home and frankly why the “Book-It” approach should not be used at all for lending purposes:

1. The “Book-It” approach ignores condition.

The values published in the value guides typically assume that the home is in average condition. This may be the case but since the home has not been inspected we really don’t know. Since condition can impact the value of the home by as much as 40 or 50%, ignoring condition can be dangerous to the health of a lender’s loan portfolio.

2. The “Book-It” approach does not verify size.

The size that the lender was given, which was used to look the home up in the value guide, probably came from the title. However, it isn’t unusual for the size on the title to be wrong. Many title sizes include a three or four foot hitch in the length and can include as much as a full foot on each side of the home for the overhangs. Making the assumption that the home is four feet longer than it really is and two feet wider than it really is can result in the book value being overstated by as much as 15%.

3. The “Book-It” approach ignores location.

The values published in the value guides typically assume that the home is in an average location. This may be the case but since the location has not been inspected we really don’t know. Since location can impact the value by as much as plus or minus 20%, ignoring location can be dangerous to the health of a lender’s loan portfolio.

4. The “Book-It” approach relies on knowing the make and model of the home.

In order to look the home up in the value guide you need to know the make and the model of the home. This presents several problems. The first problem is that 50% of the time the model is unknown. You might know that it is a Skyline but you do not know which Skyline model. Since the value guides list as many as one hundred and fifteen Skyline models, each with different values, any attempt at selecting a model would be an arbitrary guess.

The second problem is that many times you need to know more than just the make and the model. Frequently you need to know the make, the model and the series. For example, let’s say that you determined that the subject home is a Skyline Homette. You open the value guide to Skyline Homette and discover that there are twenty-seven different types of Skyline Homette with a value range of $12,000 to $17,000 for the year and size of your subject home. Guessing at which end of the range your subject home belongs could result in overstating or understating the value of your home by 30 – 40%.

5. The “Book-It” approach creates the possibility of adverse selection to the lender.

The reason the “Book-It” approach may result in adverse selection to the lender is that a well-maintained home in a beautiful community may book out at significantly less than the sales price whereas a thrashed house in an undesirable community may book out at more than the sales price. In this situation the lender may inadvertently be willing to finance the thrashed house in the undesirable community and pass on the well-maintained home in the beautiful community.

6. The sixth reason not to use the “Book-It” approach is perhaps the most important. The value guide publishers warn that the value guides should not be used for lending purposes without an inspection of the home.

However, even with this warning many lenders still just “Book-It” because it’s easy to do — easy but dangerous to the financial health of a lender’s manufactured home portfolio.

Some lenders even use a variation of the “Book-It” approach in which they finance 120 – 140% of the book value. The reason some lenders do that is because they know that the average book value is too low so they increase it by 20 or 30 or 40% on the basis that the home probably has components and accessories that warrant this increase.

However that practice too is dangerous because the resulting value may be much too high in poor markets or for homes in poor condition, and may not be high enough in good markets or for homes in excellent condition.

Again, the result is adverse selection against the lender.

So much for the “Book-It” approach. Now let’s look at the “Inspection Adjusted Book Approach.”

This approach starts with an interior and exterior inspection of the home. The inspection process focuses on:

• inventorying the components and accessories of the home.

• evaluating the interior and exterior condition of the home.

• measuring the actual size of the home.

• assessing the desirability of the location.

Once the inspection has been completed the book value is modified, typically using the value guide publisher’s forms, to adjust the book value
based on condition, location, actual size, components and accessories.

Let’s see what might happen if we used this approach on the 1991 Redman Venture Villa, 28 x 56, we referred to earlier.

Based on the inspection we learned that:

• the home’s actual measurements were 27 x 53.

• the condition was above average.

• the components and accessories were inventoried and determined to have a value of $6423.

• the location was assessed to be significantly above average.

Based on this new information combined with the book value, it was determined that the home’s value was $42,549

So now we have a “Book-It” value of $26,561 and an “Inspection Adjusted Book Approach” value of $42,549

Which one is right?

Before we answer that question let’s look at one more way to determine the value of a manufactured home. We will refer to this method as the “Comparable Approach.” This approach can be used in conjunction with the value guides or independent of the value guides.

The “Comparable Approach” includes the entire inspection process as described in the “Inspection Adjusted Book Approach.” In addition to inspecting the condition and the location and inventorying the components and accessories and measuring the actual size, the “Comparable Approach” inspection also assesses the quality of the home. (The primary benefit of assessing the quality of the home is that the need to know the make, model and series as described above no longer applies.)

In the “Comparable Approach” the home’s value is determined by comparing it to recently sold, like quality homes with similar size, age, condition, components, accessories and location. For example –– if we found three identical homes that were recently sold for $30,000 we could safely conclude that the subject home was worth $30,000. However, since in the real world any two homes are probably not totally identical, the appraiser makes adjustments to compensate for the differences.

The “Comparable Approach” is the approach that has been used by the Real Estate Industry since ________.

Most people would agree that the “Comparable Approach” is the most accurate. However, many lenders do not use it because it’s a lot more work, takes time and costs money.

When we applied the “Comparable Approach” to our 1991 Redman Venture Villa we concluded that the appraised value was $36,000. This compares to the “Book-It” approach of $26,561 and to the “Inspection Adjusted Book Approach” value of $42,549.

I believe we can conclude that the “Comparable Approach” is the most accurate method of determining value –– but it is also the most difficult to do. In some markets it is almost impossible to find good, local, recent, comparable sales and it may take a little longer than the other approaches.

Now let’s address the question of how these various valuation methods might impact the profitability of a lender’s manufactured home portfolio.

Most lenders would agree that there is an inverse correlation between owner equity and the probability of repossession. In other words the lower the owner equity, the higher the probability of repossession.

Given this premise, let’s look at how an appraisal can help the lender certify that there is owner equity by reviewing the following example.

Let’s say Mr. Smith was the buyer of the Redman Venture Villa that we described above. Let’s assume that he paid $35,000 and put 10% down.

If the lender that Mr. Smith applied to for financing used the “Book-it” method to determine collateral value, a good loan would have been turned down because the “Book-It” value was only $26,561.

If the lender Mr. Smith applied to for financing used the “Inspection Adjusted Book Approach” method to determine collateral value, this home could have been sold for as much as $42,500 and the lender might still have approved the loan. A sales price of $42,500 would have put Mr. Smith into a $6,500 negative equity position and unbeknownst to the lender would have been a high risk loan because it may take years before Mr. Smith develops any equity in the home.

If the lender Mr. Smith applied to for financing used the “Comparable Approach” to determine collateral value, the lender would have had reasonable assurance that Mr. Smith’s equity was the difference between the $36,000 appraised value and the 90% of the $35,000 that was financed.

The conclusion of this analysis is that the more accurate the appraisal, the greater the lender’s assurance that the loans being bought are adequately collateralized.

In addition to accurate appraisals being sound business practice for today’s lenders there are two other benefits.

1. Accurate appraisals help lenders detect down payment fraud. (See Marty Lavin’s article in the October 1998 issue of the Merchandiser.) As Mr. Lavin indicates in his article, “While fraudulent loans are not certain to lead to default, they do lead to a much greater incidence of default.” In addition to the eleven excellent suggestions Mr. Lavin lists to reduce the incidence of sales fraud I would add one more –– Use a credible appraisal approach to verify the collateral value of the home being financed and the collateral value of the trade-in that is being used as the source for the down payment. In the case of the Redman Venture Villa, an “Inspection Adjusted Book Approach” appraisal may have allowed the selling price to be increased to cover for a nonexistent down payment. A “Comparable Approach” appraisal would have alerted the lender to potential down payment fraud.

2. Accurate appraisals increase the secondary market’s confidence in a lender’s portfolio resulting in improved probability of sale at perhaps better pricing levels.

So what should a lender look for in the process of determining the value of a pre-owned manufactured home?

I would suggest at least the following five components:

1. Make sure that a physical inspection of the home is being done.

2. Make sure that there is a location/community evaluation.

3. Make sure that no one is guessing at make/model.

4. Make sure that whoever is doing your appraisals is independent and has your best interests in mind. The reason I say that is because there is an element of subjectivity in appraising that can be used against you if the person doing your appraisals doesn’t have your best interest in mind.

5. Recognize that a comparable-based appraisal is more accurate than a cost-based appraisal but that it is more difficult to do.

Author: Ted Boers, Datacomp Appraisal Services
Bio: Ted Boers is the founder of Datacomp Appraisal Services a company that specializes in mobile home values and valuation and operates MHVillage.com which is a website that specializes in the mobile home industry.

Does Collateral Matter?

Part I

Most of us have heard about the “C’s” of lending: Credit, Capacity, and Collateral. Most bankers recognize the need to take all these “C’s” into consideration in the process of evaluating the creditworthiness of a prospective customer.

The question that this article addresses is — How important is collateral when financing a manufactured home? Does collateral matter?

In today’s competitive financing environment there is a tendency to overlook the importance of collateral. However, because a competitive financing environment may result in financing loans on the more marginal end of the spectrum, collateral is more important than ever.

Combining marginal credit with inadequate collateral value may result in an unprofitable loan portfolio. One way to prevent that is to use an appraisal to evaluate the adequacy of the collateral as a standard component of the loan approval process.

There is a train of thought that suggests that collateral doesn’t matter; all manufactured homes depreciate and therefore financing manufactured homes is strictly a credit business.

Obviously credit is important but collateral does matter, and according to a study by the University of Michigan half of all manufactured homes do not depreciate. Studies completed by Datacomp Appraisal Systems confirm that fact.

Since Datacomp is in the manufactured home value business, Datacomp has studied value behavior, value trends, depreciation and appreciation for over twelve years. Datacomp research has consistently shown that many manufactured homes appreciate. It is also clear from this research that most homes that do depreciate do so at the rate of one or two percent per year. This level of depreciation is typically not a problem for lenders who verify that there is adequate collateral value as part of the credit approval process. If there is adequate collateral value at the beginning of the loan, the payoff balance tends to go down faster than the value, given a normal rate of depreciation.

So the key to maintaining a reasonable balance between loan payoff and collateral value is to accurately determine the collateral value at the beginning of the loan. That can best be done by an appraisal of the home.

We tend to blame depreciation whenever a home resells for less money than its original sale price. For example, let’s say a home is originally purchased for $35,000 and resold five years later for $32,000. Concluding that the home depreciated $3,000 over five years assumes that the home had a market value of $35,000 when it was purchased. That may not necessarily have been the case. Just because someone paid $35,000 for this home does not necessarily mean that it had a market value of $35,000.

Why would someone pay more for a home than it is worth? The main reason is that the buyer does not know what the home is worth. The buyer may be relying on the lender’s willingness to lend ninety percent of the purchase price as confirmation that it is indeed worth that much.

In this case the loss in value may not have been caused by depreciation at all but rather by the fact that the home was originally sold for more than it was worth.

Financing homes that are sold for more than they are worth dramatically increases the risk of repossession because the owners will have a difficult time selling their home for enough money to cover the payoff balance for at least the first eight to ten years of their loan. In addition, repossessions caused by inadequate collateral value tend to have higher loss severity.

So Collateral is important and it is clearly in the lender’s best interest to make sure that the collateral value is adequate to support the loan. Lenders who get an independent appraisal and make it an integral part of their credit decision process typically have lower repossession frequency and severity and more profitable loan portfolios.