The Credit Write-Up and the CRE Analytical Process (Session #1)
Q: Do Subchapter S corporations, partnerships, and limited liability companies all issue a Schedule K-1?
A: Yes. All three “pass through” entities use the Schedule K-1 to report the pro rata share of taxable earnings and IRS-authorized deductions for the receiving owner, partner, or member for inclusion in their personal tax return. The amount of cash distributions and other factors affecting the owner’s basis are also reported.
Q: What’s the difference between a partner and a general partner?
A: The term “partner” is used to describe all owners of a partnership. The scope of this all-encompassing generic term references both general partners and limited partners.
Q: Under what circumstances, or specific loan scenarios, should the collateral valuation be considered?
A: The lender should always consider collateral value when making a new loan. Obtaining an appraisal is a critical part of the due diligence associated with analyzing the income-producing property as the lender’s third source of repayment. The estimated market value and other content of a professionally prepared appraisal is an essential part of evaluating collateral.
A prudent lender should also consider collateral value if market conditions change significantly during the life of the loan or when a borrower’s ability to repay the loan is in serious jeopardy. It is critical to update an appraisal and re-consider collateral value in the face of imminent foreclosure and liquidation of the collateral to anticipate the amount of potential loss in such a sale.
Q: Why would a business owner or manager manipulate the depreciation expense as we saw for Sequoia Properties? How does that favor them? Why would it favor the company to under-report expense and consequently over-report profits?
A: Intentionally underreporting depreciation or any operating expense /production cost is generally considered to be an act of fraud. By understating expense, a business manager is overstating profit as you observed and might be able to gain some temporary favor from managers, investors, or lenders that use the information in making decisions that affect the business.
It’s important to recall that only a small number of our borrowers intend to defraud us as lenders. It’s therefore critical that we thoroughly investigate financial reporting that seems in error or just doesn’t make sense. This investigation is especially important when the financial statements are not reviewed or audited by the third-party accountant. In using company-prepared statements or an accountant’s compiled statements, we must recall that legitimate errors might be the cause and that the business can and will readily correct honest errors.
Q: What is the nature of the Note Payable presented on the balance sheet for $20,910,939? Does this represent the aggregate of the company?
A: As explained in Note 4 (page10 in the financial statements), this $20,910,939 of debt includes “…long-term debt outstanding from 17 different institutions and lenders…” At year-end 2013 the total also included $4,112,432 of personal loans by Mr. Schumacher converted to equity during 2014.
This amount does not represent the aggregate debt of the company. Sequoia’s aggregate or total debt is described as Total Liabilities and was $28,469,653 at year-end 2014 and $25,091,689 at year-end 2013.
Q: The $3.400,000 loan amount requested roughly equals the Current Maturities - Notes Payable ($1,084,000) and Accounts Payable ($2,367,000). Is this a coincidence?
A: Yes. The proposed loan proceeds are intended to, and if the loan is granted will, fund part of the proposed $5,575,000 apartment complex purchase price. Please note that the combined and coincidental amount due on two of the most pressing current liabilities will not be paid by our loan proceeds since we will pay the loan proceeds directly to the seller.
Course overview: The Credit Write-Up and the CRE Analytical Process