LENDING BLIND: What You Don't Know Can Hurt You
There is no question we are in a fiercely competitive commercial lending market. Banks and other lenders have more money to lend than credit worthy borrowers seek to borrow. Interest rates remain historically low. Pressure continues to mount to lower lending costs to attract new customers.
Commercial real estate lending is no exception. Banks are battling for borrowers and, in the theme of cutting costs, many banks are placing more responsibility for documenting commercial real estate loans on loan processors with only limited knowledge of the fundamental risks involved. An unfortunate consequence is that many lenders are "lending blind".
What is "lending blind"? Lending blind is approaching commercial real estate lending with substantially the same approach as lending to residential homeowners. Lending blind is making loans secured by commercial real estate without fully understanding the underlying commercial real estate project and the collateral risks it presents. Lending blind is closing one's eyes to important legal, environmental and land use issues uniquely applicable to commercial real estate and ignoring available risk-shifting techniques in the hope or unfounded belief that if the issues are not carefully considered, maybe they won't exist.
Make no mistake: Commercial real estate lending is not the same as residential real estate lending. Many bankers and other lenders faced with customer resistance to higher loan costs may wish to close their eyes to this reality. Ignoring this reality, however, does not change it. Ignoring this reality may on the surface seem to cut costs, but it can endanger bank profits and jeopardize capital.
"Sound and safe lending practices" is not just a phrase used by banking regulators. It should be a way of doing business.
Failing to focus on genuine risks presented by commercial real estate lending is not a sound and safe lending practice.
Believing a commercial real estate loan is properly documented through use of pre-packaged computer generated loan documents, without also requiring qualified, in-depth analysis of land use controls imposed by documents of record and zoning, knowledgeable examination of survey, lease subordination, insurance, access, borrower authority and other legal issues, and without fully understanding environmental risks presented by existing, former or contemplated tenants, occupiers, and adjacent land owners, is not following sound and safe lending practices.
Blindly following a loan document check-list and filling the loan file with documents and materials that "evidence" a well documented loan, without a genuine understanding of the limitations, pitfalls, and legal red flags the documents may raise, is not following sound and safe lending practices.
Using the ostrich approach to lending is a game of Russian Roulette. The result can be catastrophic to bank profits and capital if and when the loan goes bad.
Banks and other commercial lenders following these unsound and unsafe banking practices do not like this message. They often assert their loan processors are "good people" with excellent training and years of experience using their canned document software.
The fact that a lender's in-house loan processors are "good people" is not in question. The fact that they are well trained to input relevant data so a computer can generate a beautiful set of loan documents is not the issue.
The issue is what may lie beyond the documents.
A perfectly generated set of "standard loan documents" may be of little value if they fail to adequately address unique issues raised by the commercial real estate project serving as collateral. To be certain, each commercial real estate project is different. Unlike owner-occupied residential real estate, it cannot safely be "assumed" that commercial real estate collateral is legally suitable for, or can even legally be used for, its intended use.
A beautifully drafted Mortgage on commercial real estate is of little value if the project does not have a legal right to commercially reasonable access or parking. CASE IN POINT: How secure is a loan on an 800 person banquet facility in a mixed use center if the banquet facility has a legal right to park only 155 cars? CASE IN POINT: What is the collateral value of a hotel on a highly visible highway interchange, which has as its primary means of access only a license to use a private drive that can be closed at any time? [Is the appraiser legally responsible for discovering this fact when making the loan appraisal? What kind of access does the typical title insurance policy insure?]
Obtaining a Lender's Title Insurance Policy with specialized commercial endorsements is a useful method of shifting risks away from the lender, but the lender must understand how to interpret each endorsement to know what it insures. CASE IN POINT: While attending a loan closing as an "accommodation" for a lender making a large loan to one of its "best customers" to purchase a warehouse and manufacturing building, with instructions from the lender to simply "oversee execution of closing documents (the lender had prepared) and approve title", it was discovered by lender's counsel upon review of the lender's required zoning endorsement that the borrower's intended use of the facility was expressly prohibited by the applicable zoning ordinance. The ALTA 3.1 Zoning Endorsement to be attached to the loan policy disclosed that the borrower's intended use was expressly excluded as a permitted use on the land. Neither the lender nor the borrower had read the endorsement or, if they had, they failed to understand its meaning. The transaction was aborted by the regretful but thankful borrower – who would have been unable to operate its business if the transaction had proceeded. Failure to recognize this restriction before funding would have almost certainly meant bankruptcy for one of the bank's "best customers" and a huge non-performing loan for the lender.
Experience shows that lenders should not assume that borrowers and their counsel will always conduct an adequate due diligence investigation to ascertain all associated risks that may impact the project and important underlying assumptions for a loan.
A lender must also avoid the trap of over-reliance upon a borrower's representations and warranties in the loan documents. If the borrower is mistaken, what is the consequence? Declaring a material default? CASE IN POINT: A Mortgage securing a $1,650,000 loan contained a warranty from borrower that "all leases encumbering the Real Estate are, and shall remain, subordinate to the lien of the Mortgage." One lease was, in fact, not automatically subordinate to the Mortgage. The Lender's Title Insurance Policy included an exception for all existing leases and tenancies. The non-subordinated lease contained a Lessee's Option to Purchase the entire strip center for $1,520,000. Will declaring a default for breach of warranty solve this defect? What is the lender's collateral position if the Lessee exercises its Option to Purchase?
The business of lending is about making sound and safe loans that profitably perform as planned. Yield is the key. Not foreclosure. The ability to declare a default and start enforcement and foreclosure proceedings is a remedy of last resort. It is not a viable substitute for diligent evaluation of material loan predicates and will rarely fix problems with underlying collateral.
Sound and safe lending requires comprehensive understanding of all relevant issues confronting each commercial real estate project serving as collateral. If lenders are going to make commercial real estate loans, they should be following sound and safe lending practices. To do this, they must either learn how to fully and meaningfully evaluate all of the attendant risks associated with their collateral, or engage counsel with specialized knowledge and experience in commercial real estate lending to perform this function.
Turning a blind eye to the uniqueness of commercial real estate collateral, and to the limitations of many well meaning but unknowing in-house loan processors, is neither a sound nor a safe lending practice.
Independent, focused and knowledgeable lender due diligence is a must.
R. Kymn Harp
Commercial real estate lending is no exception. Banks are battling for borrowers and, in the theme of cutting costs, many banks are placing more responsibility for documenting commercial real estate loans on loan processors with only limited knowledge of the fundamental risks involved. An unfortunate consequence is that many lenders are "lending blind".
What is "lending blind"? Lending blind is approaching commercial real estate lending with substantially the same approach as lending to residential homeowners. Lending blind is making loans secured by commercial real estate without fully understanding the underlying commercial real estate project and the collateral risks it presents. Lending blind is closing one's eyes to important legal, environmental and land use issues uniquely applicable to commercial real estate and ignoring available risk-shifting techniques in the hope or unfounded belief that if the issues are not carefully considered, maybe they won't exist.
Make no mistake: Commercial real estate lending is not the same as residential real estate lending. Many bankers and other lenders faced with customer resistance to higher loan costs may wish to close their eyes to this reality. Ignoring this reality, however, does not change it. Ignoring this reality may on the surface seem to cut costs, but it can endanger bank profits and jeopardize capital.
"Sound and safe lending practices" is not just a phrase used by banking regulators. It should be a way of doing business.
Failing to focus on genuine risks presented by commercial real estate lending is not a sound and safe lending practice.
Believing a commercial real estate loan is properly documented through use of pre-packaged computer generated loan documents, without also requiring qualified, in-depth analysis of land use controls imposed by documents of record and zoning, knowledgeable examination of survey, lease subordination, insurance, access, borrower authority and other legal issues, and without fully understanding environmental risks presented by existing, former or contemplated tenants, occupiers, and adjacent land owners, is not following sound and safe lending practices.
Blindly following a loan document check-list and filling the loan file with documents and materials that "evidence" a well documented loan, without a genuine understanding of the limitations, pitfalls, and legal red flags the documents may raise, is not following sound and safe lending practices.
Using the ostrich approach to lending is a game of Russian Roulette. The result can be catastrophic to bank profits and capital if and when the loan goes bad.
Banks and other commercial lenders following these unsound and unsafe banking practices do not like this message. They often assert their loan processors are "good people" with excellent training and years of experience using their canned document software.
The fact that a lender's in-house loan processors are "good people" is not in question. The fact that they are well trained to input relevant data so a computer can generate a beautiful set of loan documents is not the issue.
The issue is what may lie beyond the documents.
A perfectly generated set of "standard loan documents" may be of little value if they fail to adequately address unique issues raised by the commercial real estate project serving as collateral. To be certain, each commercial real estate project is different. Unlike owner-occupied residential real estate, it cannot safely be "assumed" that commercial real estate collateral is legally suitable for, or can even legally be used for, its intended use.
A beautifully drafted Mortgage on commercial real estate is of little value if the project does not have a legal right to commercially reasonable access or parking. CASE IN POINT: How secure is a loan on an 800 person banquet facility in a mixed use center if the banquet facility has a legal right to park only 155 cars? CASE IN POINT: What is the collateral value of a hotel on a highly visible highway interchange, which has as its primary means of access only a license to use a private drive that can be closed at any time? [Is the appraiser legally responsible for discovering this fact when making the loan appraisal? What kind of access does the typical title insurance policy insure?]
Obtaining a Lender's Title Insurance Policy with specialized commercial endorsements is a useful method of shifting risks away from the lender, but the lender must understand how to interpret each endorsement to know what it insures. CASE IN POINT: While attending a loan closing as an "accommodation" for a lender making a large loan to one of its "best customers" to purchase a warehouse and manufacturing building, with instructions from the lender to simply "oversee execution of closing documents (the lender had prepared) and approve title", it was discovered by lender's counsel upon review of the lender's required zoning endorsement that the borrower's intended use of the facility was expressly prohibited by the applicable zoning ordinance. The ALTA 3.1 Zoning Endorsement to be attached to the loan policy disclosed that the borrower's intended use was expressly excluded as a permitted use on the land. Neither the lender nor the borrower had read the endorsement or, if they had, they failed to understand its meaning. The transaction was aborted by the regretful but thankful borrower – who would have been unable to operate its business if the transaction had proceeded. Failure to recognize this restriction before funding would have almost certainly meant bankruptcy for one of the bank's "best customers" and a huge non-performing loan for the lender.
Experience shows that lenders should not assume that borrowers and their counsel will always conduct an adequate due diligence investigation to ascertain all associated risks that may impact the project and important underlying assumptions for a loan.
A lender must also avoid the trap of over-reliance upon a borrower's representations and warranties in the loan documents. If the borrower is mistaken, what is the consequence? Declaring a material default? CASE IN POINT: A Mortgage securing a $1,650,000 loan contained a warranty from borrower that "all leases encumbering the Real Estate are, and shall remain, subordinate to the lien of the Mortgage." One lease was, in fact, not automatically subordinate to the Mortgage. The Lender's Title Insurance Policy included an exception for all existing leases and tenancies. The non-subordinated lease contained a Lessee's Option to Purchase the entire strip center for $1,520,000. Will declaring a default for breach of warranty solve this defect? What is the lender's collateral position if the Lessee exercises its Option to Purchase?
The business of lending is about making sound and safe loans that profitably perform as planned. Yield is the key. Not foreclosure. The ability to declare a default and start enforcement and foreclosure proceedings is a remedy of last resort. It is not a viable substitute for diligent evaluation of material loan predicates and will rarely fix problems with underlying collateral.
Sound and safe lending requires comprehensive understanding of all relevant issues confronting each commercial real estate project serving as collateral. If lenders are going to make commercial real estate loans, they should be following sound and safe lending practices. To do this, they must either learn how to fully and meaningfully evaluate all of the attendant risks associated with their collateral, or engage counsel with specialized knowledge and experience in commercial real estate lending to perform this function.
Turning a blind eye to the uniqueness of commercial real estate collateral, and to the limitations of many well meaning but unknowing in-house loan processors, is neither a sound nor a safe lending practice.
Independent, focused and knowledgeable lender due diligence is a must.
R. Kymn Harp
posted by R Kymn Harp | 7:12 PM
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