Probably the single most important process in commercial real estate lending is due diligence on the primary and secondary sources of repayment. A key factor in any due diligence is vetting what the borrower states concerning actual and projected annual revenue and expenses and understanding the potential risks associated with the loan’s collateral.

Borrower and Collateral

Certainly all borrower documents and claims need to be verified. In that regard, I am aware of a case on a construction and permanent loan facility that was impaired where certain borrower statements were not vetted correctly. As it turns out, the loan underwriter actually increased the loan’s balance up to the borrower’s pro forma revenue projections versus actual. Had the loan underwriter just spent thirty minutes confirming what the borrower said with the building department as to what was allowable under current zoning, he would not have made this mistake; a mistake that ultimately cost the bank several million in loan losses. Granted it may seem obvious that you don’t look to pro forma revenue; however, sophisticated borrowers can submit information that on its surface looks reasonable and therefore, needs to be verified.

Even if the lender has a standardized, checklist of due diligence issues, it is important to understand that confirming the accuracy of critical documents is a part of a best-in-class due diligence process.

Aspects of Due Diligence

Lender due diligence requires the examination of the following key areas:

• The borrower or person/entity guarantying borrower’s obligations

• The real property, improvements, and fixtures securing the loan

• Title to the real property

• Real Property Survey (including the type of survey; for example, as-built versus boundary)

• Zoning and use

• Leases and contracts

Additionally the lender will need to review all potential or existing issues that may have an adverse effect on use, value, operation, and on the borrower’s ability to perform under the loan documents, including:

• Judgments against the borrower or guarantor;

• Environmental contamination

• Liens against the property

• Lease defaults or tenant bankruptcies (including rent roll and/or estoppel that provide information concerning the likelihood of a pending bankruptcy)

• Ongoing litigation

• Confirm that the borrower and any guarantor have been established as required and that the entity is in good standing

• That the borrower is authorized to enter into a loan agreement and that the borrower has the necessary authority to do business in the state where the real property is located

• Confirm that all documents that are intended to be recorded are conforming and that any local reporting requirements are completed

• That there is adequate consideration for each guarantor

• Understand the formation and reporting for each type of entity: general partnership or limited partnership; limited liability company; joint venture

As California is a non-judicial state, most often the loan is non-recourse and the real property is the primary source of repayment. This is true for off-balance sheet, non-recourse conduit loans. Specific to commercial real estate underwriting and due diligence, the following are areas that must be examined and understood prior to any commitment:

Title Issues

Lender of course wants to not only confirm the borrower’s ownership but that the title is marketable and that there are no encumbrances or defects to title.

Schedule A

• Confirm that the entity is correct

• Verify legal description and address (confirm that legal description is the same on all deeds and relevant loan documents and survey)

• Determine type of policy

• Confirm date of policy and whether it should be updated

• Verify that insured amount equals purchase price

Schedule B

• If applicable, review mortgage schedule (determine who are the lenders, total borrowed)

• Check for other liens, including tax or judgments recorded against the property

• Review all CC&Rs

• Confirm that the property has both legal and physical access

• Review all easements recorded against the property

Any major commercial real estate project should require an as-built survey; this will be necessary in order to obtain an ALTA title policy. An as-built survey will identify any potential encroachments, setback violations, and boundary issues that may exist and whether they are curable. Additionally, effective February 23, 2016, ALTA and NSPS revised the minimum standard detail requirements for land title surveys.

This should also include a municipal search and violations that may exists, including potential building permit, certificate of occupancy, and other use/zoning defects.

Lease Analysis

This is a critical part of the lender's review as the quality of the property’s cash flow and viability are dependent on the property’s tenant lease profile. The lease review should include:

• Existing lease options (e.g. first right of refusal, including purchase option)

• SNDA requirements

• Tenant estoppel and certificate

• Borrower funding obligations under the lease

• Unpaid leasing commissions

• Termination rights

• Set-off rights granted to tenant

• Status of all tenant improvements

• Lease language that may conflict with the casualty provisions in the loan documents as to distribution of insurance proceeds

• Co-tenancy clauses, operating covenants, and exclusive use clauses

• Existing indemnities (e.g. borrower indemnifying the tenant for environmental contamination)

Also it is important that the lender understand the tenant’s creditworthiness. Also how do the current contractual rents compare to current market rents. This will be a factor in looking at the risks associated with tenant defaults and also collateral value.

Property Risk Management

Environmental review should include a phase-one and phase-two study. CERCLA provides for joint and several liability of current owners and operators of real property contaminated by hazardous substances.

Federally regulated banks, mortgage companies, loan servicers, and other lending institutions cannot make, extend, renew, or increase a loan on improved real estate located in a Special Flood Hazard Area.

Seismic is another issue, especially with property located in California. A Probable Maximum Loss (PML) may be required; also do the improvements meet Title 24 and other jurisdictional retrofit requirements for seismic.

Submarket Review

Is the submarket in equilibrium? Are there significant barriers to entry? Is the property located in an area where there is potential use or industry sector concentration risks? Do current demographical trends support the value (e.g. reversionary value and how it is factored into the property’s NPV)?

Collateral Considerations

In a down market, with high vacancy, the more special purpose an asset’s design and intended use, the more difficult it can be to find a replacement tenant. Is the design and use fungible? Is it so special purpose that the likelihood of locating another tenant would be problematic? Is there adequate parking? How is ingress/egress to the site?

Personal Property Security Interests and UCC Filings

In commercial real estate lending there may be specialized product types including restaurants, hospitality, and retail uses. For example, with restaurants and hospitality personal property and UCC status are important and should be a part of the lender’s due diligence. Status of the liquor license may also be an important issue. Is there a franchise agreement? Is the property and franchisee in good standing? Is there a PIP report that shows that major soft and hard good replacement is required to maintain the franchise? What are the personal property security interests and the UCC filing status?

Conclusion

Lender due diligence is not a static process. The collateral, borrower, and economic conditions can change significantly overtime. Therefore, on-going collateral and financial audit and review is necessary to insure that any potential impairment is identified early. Real estate markets are always cyclical. There is no exception. The better a lender is in their thoroughness in underwriting the primary and secondary sources of repayment, the better their position will be in avoiding any unnecessary loan losses and liabilities.

Article written by Conrad Andersen, Executive Managing Principal of The Syntax Group.

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