Floor Plan Underwriting loans to auto dealers

 Lending to automobile dealerships

New car dealerships in the US work under franchise agreements with car manufacturers. Dealerships are sophisticated retail operations with separate revenue streams. Although selling new automobiles is the driver behind sales volume and customer traffic to their showrooms/lots other sources of revenue and profitability include the sale of used cars, automobile repair and maintenance, and customer financing.

Financing the operations of a car dealership requires a specialized type of loan called a “floor plan line of credit”. The floor plan facility allows the automobile dealer to obtain financing for automobile inventory.  Advances under the facility are made against specific automobiles as collateral.  When each automobile is sold, the loan advance against that particular piece of collateral is repaid.  The dealer borrows against their retail inventory, repays the loan when they sell their inventory and borrows against the line of credit again to add new inventory.

Your dealer customer will probably need a comprehensive financing solution that allows it to borrow against the new cars as well as the used cars in its inventory. It is very essential that when setting up the loan structure that terms for each one of these types of inventory are built into the loan agreement. From the point of view of risk management, it is important that the riskier nature of used car inventory is mitigated by stricter terms. The way it has usually been handled is by granting two cross-collateralized/cross-defaulted floor plan lines. One for new cars and a second one for used cars.

Structuring the Floor Plan:

1)                  Advance Rate: For new automobiles, the industry standard is 100% of cost. For used automobiles, advances are also usually 100% based on the lesser of cost or average trade-in value as listed in NADA. A common error is to omit the “lesser of” language in the loan agreement or base advances on the “clean” trade-in value. A good dealer will more than likely be getting trade-ins by paying the average, resulting in over advances by the lender.

2)                  Curtailment: In Floor Plan lingo curtailment is a fancy word that means amortization. For new cars, you want to set up your curtailment to coincide with the introduction of the next year’s models. This usually happens around October. I have seen this implemented several ways, but it is usually a rapid curtailment of at least 10% monthly. For used cars, you want the curtailment to be accelerated. I have seen used car floor plans that curtail advances every month by 10%, and I have seen other used car floor plans that require each advance to be paid in full within 6 months. There is a certain range where the structure can be negotiated depending on your employer’s appetite for risk and the competitive environment.

I think curtailment as a concept is explained better if I give you an example and work you through it. So lets assume that you currently have a floor plan line of credit out to a Ford dealership that allows for 100% advances on the cost of new vehicles, and requires curtailments of 10% per month for five months starting in October {introduction of next year’s models} and then the borrower has the option to move the remaining outstanding to the used floor plan line of credit or payoff the balance. A typical transaction would fund as follows.

- On April 2, 2012. The borrower requests an advance for $16,500 representing 100% of the invoice for an entry level 2012 Ford Focus.

- On October 1, 2012. It has been about 6 months and the borrower has not been able to sell the Ford Focus. Since the 2013 models are now arriving for sale, your loan agreement requires a 10% curtailment {$1,650} reducing that advance outstanding to $14,850.

- The car remains unsold for several months, and the lender receives four more payments of $1,650 on Nov. 1st, Dec. 1st, Jan 1st, and Feb. 1st.  reducing the amount outstanding in the vehicle to $8,250,

- When March 1st 2013 comes around the borrower will either pay the remaining $8,250 or move the car to the used car floor plan line where it will start getting curtailed within 30 days. However, there is a benefit for the dealer since the curtailment will be based on the $8,250, its cash flow will not be affected as much.

3) Amount of the line: Like any other financing facility, the line must fit the financing needs of the borrower with some restraints to avoid excessive leveraging or over extension. A good rule of thumb is new car floor plans that allow for 90 days of inventory, and used floor plan lines that allow for 60 days of inventory.

4) Other restrictions: Stay away from really old inventory. Putting a limit on the age of the used vehicles to be considered eligible is appropriate. Limiting the number of “loaners” in the new vehicle pool is also appropriate.

Controls:

Just like any other facility a set of well though out financial covenants is required to keep control of the relationship. However, it is very important that an audit component is incorporated into the loan. The audit is simple, you show up with the latest inventory report and make sure that all of the cars are still in the possession of your borrower. A couple of years ago, my department would do this for the couple of floor plans in our books. Since then, we have moved to outsourcing it to a firm that specializes in this service.

The other aspect to consider is whether or not the lender will require that titles and Manufacturer’s Origin Statement (MOS) are delivered. It is my belief that having them in the lender’s possession is best practice, but some of our competitors do not require it. While I can understand the argument that if the borrower wanted to commit fraud all it needs to do is request a duplicate title, I like for them to have to do an extra step if they decide to not play by the rules.

This is just a brief introduction into this type of specialized financing. I hope that it gives you a basic understanding and helps you if you have a dealer customer approach your institution.

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