Many people have traditionally shied away from art investing because paintings and sculptures are “non-liquid” assets, (i.e., they are not easily converted into cash). A substantial percentage of businesspeople were precluded from art investing because large deposits of cash or cash equivalents had to be kept available for business operations, real estate development or maintenance, and margin calls. Realizing that there were many potential art investors who were put off by art’s non-liquidity, Wall Street responded by providing a new financial product—art financing.
To fully appreciate this art lending, a little background is in order. Historically, lenders did not consider accepting art as collateral since its liquidity approached zero. Establishing prices and evaluating marketability was also extremely difficult because, in the past, the art demand was much weaker and more sporadic. As a result, when art financing claimed its first toehold in the United States, it was perceived as a super-esoteric, micro-niche industry. It was a financial product that was available only to an extraordinarily small subset of art collectors, i.e., those who owned the most coveted masterworks by a handful of the most world-renowned artists. Such works, and only these works, could overcome lenders’ prejudice against art as notoriously illiquid collateral. Thus, art financing remained for many years an oddball banking product of little use.
Since the 1990’s, a river of new collectors has dived into the art market. No longer is art collecting perceived as a rarified, leisure activity. It’s now big, mainstream business, and with the explosion of wealth coming with our new techno-economy, successful entrepreneurs are collectively investing billions of dollars in fine art. Steady upward demand for fine paintings and sculpture and a concomitant response in their supply has made art commerce more stable and somewhat more predictable, improving liquidity. Wall Street finally started to take fine art financing seriously with the advent of “guaranteed” art auction prices now offered by the most prestigious auction houses Those guarantees function as failsafe mechanisms that substantially reduce the financial risks of art transactions, thereby improving fine art’s suitability as lending collateral.
For the current year, it has been estimated that the world’s financial institutions will have extended $460 billion in art-backed loans. Borrowers typically use these loan proceeds to achieve one of the following objectives:
A. Generating tax-free proceeds to be invested in an income-generating asset or business;
B. Purchasing more pieces while simultaneously deferring the payment of capital gains tax;
C. Exploiting relatively low-interest rates to fund arbitrage or high-yielding financial speculations;
D. Satisfying federal inheritance tax obligations; and
E. Meeting short-term cash needs via “bridge” or “gap” loans.
Most major banks now have dedicated art lending departments or private banking divisions that regularly facilitate the borrowing against art. Like all specialty lending, art financing is burdened by certain requirements and confined within certain general parameters. The following are typical terms and conditions:
Nature and Genre of Acceptable Art Collateral
Impressionist, Modern, Post-War, and Contemporary artworks are usually preferred as collateral by fine art lenders. Although these are the most frequently pledged, art financiers occasionally also accept exceptional pieces by Old Masters and internationally famous artists. The bottom line is that the genre and artist of your proposed collateral must have a proven track record. If you have multiple pieces to offer as collateral, a professional art advisor can help you prepare the smallest acceptable collateral portfolio so that at least some of your treasured pieces won’t need to be delivered as part of an offsite pledge.
Ancient artifacts, especially those originating in the Middle East, are typically not accepted as collateral because of recent looting concerns. Some types of artifacts are rejected because they are often faked and/or exceedingly difficult to authenticate, such as is the case with Pre-Columbian Art. Moreover, a cottage industry exists in forging the works of certain high-profile contemporary artists, and many lenders will steer clear of them. Again, a professional art advisor should be consulted if you are concerned about whether your collection constitutes appropriate collateral. Finally, banks occasionally require you to pay for the services of a professional fine art authenticator to ensure value. Authentication is its own specialty separate and apart from both art advising and appraising.
Provenance
There is no faster way to lose credibility with a prospective art lender than by presenting sloppily assembled or incomplete provenance. Expect your lender to be just as demanding as you would be if you were purchasing the piece from a stranger. Don’t approach a lender without having your best, most reasonably complete compilation of bills, authentication reports, exhibition/gallery display documentation, receipts, invoices, auction catalogs, letters, or other physical records establishing provenance.
Title
If you don’t already have title insurance for your proposed collateral, you’ll need to procure it with the lender being a named insured in the event your ownership rights are challenged. You will need to hire a USPAP-qualified appraiser for establishing the piece’s fair market value as the indemnity amount.
Minimal Collateral Value
Most lenders will require that the total value of collections should exceed one million dollars, with no individual piece included therein valued at less than $100,000. Some of the largest lenders set the bar much higher, declining to do business for collections totaling less than $10,000,000. Some specialty lenders will allow you to borrow against smaller collections and less valuable pieces, the smallest appraised value for a single piece of collateral currently being $25,000. However, the interest rates charged by these small, private lenders are often prohibitively high.
Loan to Value Ratio
The largest institutional lenders typically advance between 40% and 60% of total value, although the loan to value ratio has been known to fall anywhere between 30% and 80% depending upon specific circumstances. Frequently, borrowers who surrender possession and physically pledge the piece to be held by the lender are offered the most favorable loan to value ratios. Although the lender typically retains, at the borrower’s expense, an appraiser to value the collateral for this purpose, the borrower should consider retaining her own independent appraiser in order to facilitate favorable negotiations with the bank. Depending upon your lender’s requirements, your pieces will be appraised at either marketable cash value (MCV), which is most favorable to the lender, or fair market value (FMV), which is the valuation most favorable to the borrower.
Interest Rates
Commercial banks typically charge the LIBOR floating daily rate plus a spread of 6% or 7%. Private, niche lenders exist who specialize in extreme short-term “gap” or “bridge” financing. Some of these lenders are allowed to charge interest percentages that would otherwise exceed a State’s criminal usury rate, e.g., 40% per annum or more. These companies should be viewed as “hard money” lenders whose principal objective is to suck as much equity as possible out of your piece or collection.
Term
The duration of art-secured loans is typically short, being one or two years. However, a few lenders allow loans up to ten years in duration. They often agree to extend the term of their loans on a year-by-year basis, but before each such extension, they will require you to obtain an updated appraisal. As stated above, gap or bridge loans can be procured by some private lenders for very short terms of days or months.
Default Rights
Most art loans fall within the category of “recourse” financing. This means that, in the event (a) the borrower defaults in repaying the loan and (b) the collateral sold by the bank falls short of the sum of principal, interest and fees owed, then the bank may sue the borrower personally to recover the deficit. Some lenders are starting to offer non-recourse financing, wherein the lender is strictly limited to the proceeds from the sale of the borrower’s collateral as his only remedy upon default, but this type of loan usually (a) costs more in terms of the interest rate charged and (b) enjoys a less favorable loan to value ratio.
Situs of Pledged Property
Unlike most European and Asian jurisdictions, the United States follows public-record filing procedures that permit the borrower to retain possession of his collateral. Thus, it is possible under the right circumstances for the borrower to retain enjoyment of the art that she is leveraging. Pursuant to the pledge, the art must stay at the borrower’s real property precisely where it is described on the UCC filing. Most significantly, the piece must be insured, the financial institution being named as an insured in the event of casualty or theft.
The benefits of standard UCC pledging notwithstanding, the borrower might find it financially advantageous to physically pledge his piece to be held offsite under the bank’s sole access and control. Borrowers who agree to offsite pledging should press for more favorable lending terms over and above what is typically offered to those who maintain possession, thereby retaining enjoyment of their pledged artwork.
Those art owners who seek “art investor” taxpayer status (instead of “collector”, “hobbyist” or “dealer” status) should seriously consider off-site pledging. If the IRS accepts your argument that you are an art “investor”, then you may (a) deduct losses on art sales against income, (b) add the costs of maintaining, securing, insuring, transporting, appraising, exhibiting, and art consultant fees to a work’s cost basis, and (c) pay tax upon its sale at the 28% capital gains rate instead of the maximum income rate of 37.4%. The IRS often argues against entitlement to “art investor” status by emphasizing the owner’s personal use of his invested art at his home. However, the IRS’s strategy in this regard is often defeated when the taxpayer delivers his art to a commercial lender as part of an offsite pledge.
Conclusion
Art financing opens new strategies for the acquisition of pieces and expansion of collections while legally deferring the payment of capital gains tax obligations. Art lending provides other income-generating art-related strategies that will be the subject of subsequent postings.
This article is written for informational purposes only. Please consult with your agents (attorneys, accountants, wealth managers, etc.).