There is no question that we are in a fiercely competitive business loan market. Banks and other lenders have more money to lend than creditworthy borrowers seek to borrow. Interest rates are historically low. Pressure continues to mount to lower borrowing costs to attract new clients.
Commercial real estate loans are no exception. Banks and other commercial lenders are fighting for borrowers, and on the issue of cost reduction, many are placing more responsibility on loan processors to document commercial real estate loans with limited knowledge of the fundamental risks involved. An unfortunate consequence is that many lenders are “lending blindly.”
What is “blind lending”? Blind loans are approaching commercial real estate loans in substantially the same approach as residential homeowners loans. Lending blindly is making loans secured by commercial real estate without fully understanding the underlying commercial real estate project and the collateral risks it presents. To lend blindly is to close your eyes to significant legal, environmental and land use issues that uniquely apply to commercial real estate and to ignore available risk reversal techniques in the hope or unfounded belief that if problems are not considered carefully, they may not exist.
Make no mistake: commercial real estate loans are not the same as residential real estate loans. Many lenders facing customer resistance to higher loan costs may want to turn a blind eye to this reality. However, ignoring this reality does not change it. Ignoring this reality may on the surface seem to cut costs, but it can jeopardize banks’ profits and jeopardize capital.
“Safe and sound credit practices” is not just a phrase used by banking regulators. It should be a way of doing business.
Failing to focus on the real risks that commercial real estate loans present is not a sound and safe lending practice.
Believe that a commercial real estate loan is properly documented through the use of prepackaged computer generated loan documents, without also requiring a qualified and in-depth analysis of the land use controls imposed by registration and zoning documents, an informed examination of the survey, lease subordination, insurance, access, borrower authority, and other legal issues, and without fully understanding the environmental risks posed by existing, former, or planned adjacent land tenants, occupants, and owners, does not you are following sound and secure credit practices.
Blindly following a loan document checklist and filling the loan file with documents and materials that “show” a well-documented loan, without a genuine understanding of the legal limitations, pitfalls, and red flags that documents can generate. is to follow sound and safe loan practices. Using the ostrich approach to borrow is a game of Russian roulette. The result can be catastrophic for profits and bank capital if the loan does not work out.
Banks and other commercial lenders who follow these unsound and insecure banking practices do not like this message. They often claim that 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 doubt. The fact that they are well trained to enter relevant data so that a computer can generate a beautiful set of loan documents is not the problem.
The question is what can lie beyond the documents.
A perfectly generated set of “standard loan documents” can be of little value if they do not adequately address the unique issues posed by the commercial real estate project that serves as collateral. Without a doubt, every commercial real estate project is different. Unlike owner-occupied residential real estate, it cannot be safely “assumed” that commercial real estate collateral is legally adequate, or can even be legally used for its intended use.
A beautifully worded 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 safe is a loan for an 800-person banquet facility in a mixed-use facility if the banquet facility has the legal right to park only 155 cars?
CASE IN POINT: What is the collateral value of a hotel at a highly visible road junction, whose primary means of access is only a license to use a private road 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 title insurance policy from a lender with specialized business endorsements is a useful method of deflecting risks 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 a “settlement” for a lender making a large loan to one of his “best customers” to purchase a warehouse and manufacturing building, with instructions from the lender to simply “supervise executing the closing documents (the lender had prepared) and approving the title, “the lender’s attorney discovered upon reviewing 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 lending policy revealed that the intended use by the borrower was expressly excluded as a permitted use on the land. Neither the lender nor the borrower had read the endorsement or, if they had, did not understand its meaning. The transaction was aborted by the sorry but grateful borrower, who would not have been able to operate his business if the transaction had continued. Failure to acknowledge this restriction prior to financing would almost certainly have meant bankruptcy for one of the bank’s “best customers” and a huge delinquent loan for the lender.
Experience shows that lenders should not assume that borrowers and their attorneys will always conduct a proper due diligence investigation to determine all associated risks that may affect the project and the important underlying assumptions for a loan.
A lender must also avoid the trap of relying excessively on the borrower’s representations and warranties in the loan documents. If the borrower is wrong, what is the consequence? Declare a material breach?
CASE IN POINT: A Mortgage securing a loan of $ 1,650,000 contained a guarantee by the borrower that “all leases that encumber the Real Estate are, and will remain, subordinate to the Mortgage lien.” A lease, in fact, was not automatically subordinate to the Mortgage. The lender’s title insurance policy included an exception for all existing leases and leases. The unsubordinated lease contained the tenant’s option to purchase the entire strip center for $ 1,520,000. Will this defect be resolved by declaring a breach for breach of warranty? What is the lender’s security position if the lessee exercises his purchase option?
The business of loans is about making strong, secure loans that work profitably as planned. Performance is the key. No foreclosure. The ability to declare a default and initiate foreclosure and foreclosure proceedings is a last resort. It is not a viable substitute for diligent evaluation of material loan predicates and will rarely fix underlying collateral problems.
Strong and secure loans require a comprehensive understanding of all the relevant issues faced by every commercial real estate project that serves as collateral. If lenders are going to make commercial real estate loans, they must follow sound and secure credit practices. To do this, they must learn to fully and meaningfully assess all risks associated with their collateral, or hire consultants with specialized knowledge and experience in commercial real estate loans to perform this role.
Turning a blind eye to the uniqueness of commercial real estate collateral, and the limitations of many well-meaning but unknown in-house loan processors, is not a sound or safe lending practice.
Due diligence from an independent, focused and knowledgeable lender is a must.