Lending to Auto Dealers in Hard Times: Traditional Lending Standards, Prudently Applied, Are Still Useful in Evaluating Potential Borrowers
Wiley, Robert, The RMA Journal
In the Traditional approach to auto dealer lending, the lender's credit policy has a well-defined groundwork that identifies an acceptable level of risk. The policy sets underwriting guidelines and establishes limits and exposures based on the overall quality of clients and manufacturers. The credit policy should target desirable markets and address franchise diversity and product mix.
A desirable market has positive economic attributes and economic health, as measured by per capita income, trends in vehicle registrations, and the local job markets. Another factor to consider is the lender's franchise footprint.
For lenders with a more national scope, desirable markets are determined by the reach of their business. Some lenders prefer large populous, urban markets--where the cars are, so to speak--whereas community banks are very comfortable lending money in their own backyards.
A multiple-franchise dealer group affords the most diversity of risk, although single-point dealers who have done well over the years are certainly not an undesirable risk. Meanwhile, for most auto lenders, product mix includes new car product, normally advanced up to 100% of manufacturer's invoice. Traditionally, the line is sized based on a 75- to 90-day supply, although a lot of dealers are over this guideline because of slower sales. The line normally would be a one-year term.
Fleet lines for auto dealers that sell volumes of cars to end users such as car rental agencies are based on historical sales levels and contracts bid. Used-car lines are advanced up to 80-90% using some method of valuation such as NADA, Kelley Blue Book, or Black Book. Typical returns on these lines are set at 45-60 days with six-month terms.
Another typical loan for automotive dealers is a term loan for equipment, capital expenditures, or acquisitions. Usually, these are three- to seven-year loans. A debt service coverage (DSC) ratio in the 1.25 to 1 range is optimal.
Finally, real estate loans include refinancings for permanent loans or construction loans for new dealerships. Typically, a 75% loan-to-value ratio toward a significant equity contribution is required. These loans should have 15- to 20-year amortizations and a shorter term, such as a five- to seven-year call. Lenders normally require a healthy DSC ratio in the 1.25 range or greater.
Underwriting a Specific Deal
Due diligence is a major part of underwriting. Evaluate the dealer's reputation, perform a background check, and evaluate the market areas. Credible references should always be obtained.
A cadre of seasoned commercial lenders entrenched in the marketplace is an invaluable resource. These seasoned lenders should know the market (and the dealers in that market), so talking to them helps ensure you're picking the right clients to do business with.
In evaluating management and ownership, the background and experience of the owner are crucial. Did the owner come up through the ranks and have experience in selling? Owner-operators are highly desirable because they're on the site every day and have an incentive to protect and grow their investment. Dealers who have sold successful dealerships in the past also are desirable.
The quality of the staff--the sales manager and the service managers, to name a few--also should be evaluated. One way to evaluate the quality of management is to see what kind of profits they have generated.
Credit Facilities Requested
In setting up the new line, consider such factors as the quality and diversity of the product represented, the sales history, and projected sales. For new cars, the line is set ideally to 75- to 90-day turns. Depending on the dealer's position, though, you may have a little bit more or less than that if it's a high-volume shop or if the dealer goes more for margins and inventory turns are a little slower. …