Due Diligence for Lenders With Distressed Assets

Article by Robbin Newman

Robbin Newman is a Partner at Holland and Knight

It is important for lenders – and their special asset/portfolio management teams - to take inventory of lenders' real estate collateral. This is especially true now that lenders have scaled back on new loans and are focused on managing their real estate collateral portfolios due to potential or pending loan defaults by borrowers. Such inventories include reviewing permits, licenses, zoning and land-use approvals, leases and other due diligence that, if neglected, could result in devaluation of the collateral.

The following discussion and checklist are designed to assist in the carrying out of this due diligence (with particular attention to Florida law).

Land Use, Zoning and Development Approvals

Review of approvals is particularly important where a given real estate loan was a bridge loan or development loan to fund the development costs for the proposed project. This includes any and all land use, zoning and development approvals required to permit the development of the proposed project. Since the lender's exit strategy for the payoff of this type of bridge or development loan was typically to occur by the closing on a new construction loan, this exit strategy will be impeded if attention is not given to the milestone dates for obtaining, and as applicable, maintaining, the project entitlements and approvals. This is of particular importance now: borrowers may have run out of their own funds and, due to a potential or pending default, the lender may have been unwilling to fund any further development costs with disbursement of loan funds. Notwithstanding that the lender may not want to invest more money into a defaulted loan, the alternative is for the lender to be left with "keys" to a vacant parcel that was on the road to vesting of entitlements, and ends up lacking entitlements. If the loan did not initially include a timeline and critical dates for the borrower to satisfy certain zoning and land use approvals, then it is important to immediately obtain this information, whether from a cooperative borrower or directly from the controlling governmental authorities. It is possible that the borrower is 75 percent or even 90 percent along the path to vested entitlements, which could greatly improve the value of the lender's collateral – even more than the potential cash outlay that would be necessary to obtain the necessary remaining entitlements.

One example would be a case in which a plat approval is pending for the subdivision of certain Florida real property – and in conjunction with the pending plat approval, there may be approved density, use, easement, traffic and other similar entitlements that will all be lost if the plat is not recorded in a timely fashion. Typically, it is extremely difficult, if not impossible, to obtain an extension for the time for recording of a plat. It is possible that with an additional expenditure of $10,000 (for example only), the plat could be completed and recorded, preserving many important approvals that ultimately will revalue the vacant property much more than the $10,000 spent to complete the plat work and send the plat to recording. Similarly, there may be permits that have been obtained by the borrower for development or construction purposes that will be void – and either not renewable or subject to further procedures before state or local agencies, if the permits are not kept current. This could be anything from a site work permit, to a water management permit, to permits issued by the Environmental Protection Agency. If a milestone date timeline with action notes was not prepared at the time of closing or thereafter, it would be prudent to immediately assemble all of this information and calendar all critical dates for action required; the aim is to obtain or maintain entitlements that will add or preserve value to the real estate collateral.

Title Updates

When a loan is subject to a potential default or is in a pending default, it is always a good idea to request a title update to review the current status of title, and to see if any liens have been filed against the property. If the lender is not getting paid, there is a good chance that others engaged to do work for the property for a development or construction loan also have not been paid. Where any of these liens are recorded after the lender's mortgage, under Florida law they will be junior and subordinate, and may be foreclosed by the lender if the loan is accelerated at the time of a default and a foreclosure action is filed by the lender. Notwithstanding the junior priority of such liens, it is possible that some of these contractors could be necessary to carry out any land use or zoning approval work that is needed for obtaining or maintaining entitlements as described above. In such a case, notwithstanding that the lien is subordinated to the lender's mortgage, the lender should first look at its loan documents to see if these contracts were collaterally assigned to the lender as additional security for the loan, and if so, whether any consents to assignment were obtained from those contractors whose contracts were not assignable absent such contractors' consent.

This can be particularly important in terms of the cost to the lender for asking a lienor to continue to do work for the lender if necessary to obtain or maintain a zoning entitlement. For example, even though the borrower may owe a civil engineer $10,000 that is also the subject of a filed mechanic's lien, a properly drafted consent delivered at the time of the loan closing may provide that even though the loan is in default, the engineer is required to continue to work for the lender as of the date of written notice to the engineer to resume working, and in such event the lender is only obligated to pay for charges incurred on a going-forward basis. This could be very key to the lender if there are multiple contractors who have filed liens, yet are necessary to continue with a project to preserve entitlements or to complete site work that must be completed pursuant to an issued permit.

As a result, lenders should do a review of their loan documents to see what assignments and what consent documents were obtained in order to facilitate contractors resuming work for lenders on a going-forward basis. In addition to searching for recorded liens, it is also a good idea to make sure that the borrower has not violated the loan documents by recording other encumbrances (i.e., covenants, restrictions or even a junior mortgage), or by conveying a partial interest in the real estate collateral to a third party.

Letters of Credit

If letters of credit were issued in connection with the loan closing, it is advisable for the lender to take inventory of any and all such documents. One reason is to make sure that the issuing bank is still in business and is not subject to FDIC control; the latter could mean that further inquiries are required in the event that a drawdown on the letter of credit becomes necessary. Another reason is to make sure that if the letter of credit was renewable, the renewals took place with payment of any required fees. In the event that the lender holding the letter of credit has changed its name or has merged or been acquired, the letters of credit should be reviewed and addressed so they can be issued in the name of the current lender.

Condominium Properties

With respect to condominium properties, lenders should be kept apprised of the status of pending sales, association assessments and collections, pending lawsuits, service contracts, and property management and maintenance of association documents. If the loan is at the stage of a potential default or a pending default, there are many moving parts to the operation of a condominium property that will ultimately need to be addressed. Before the loan gets to this stage – when the borrower may not be amenable to cooperating with the lender – the lender's portfolio/asset management team should take inventory of the information in the lender's files relating to the condominium and the condominium association; the aim here is to be prepared in case further action is taken, whether by foreclosure or deed in lieu of foreclosure. If the loan was a construction loan for constructing the condominium project, then management of potential liens and contractor claims, as well as assessment of liability for construction defects and as a potential "successor developer" if the units are taken back by the lender in a subsequent foreclosure, are additional issues that should be considered at this early stage so appropriate steps in due diligence can be taken.

Insurance and Property Taxes

Although property insurance is customarily addressed in the loan documents with provision for the lender to require evidence of insurance and to obtain insurance if the borrower fails to keep insurance in place – especially in the State of Florida where insurance is difficult to obtain in rated areas subject to high hurricane rates of coverage – the lender should take inventory sooner rather than later to make sure of the status of the insurance policies that protect the real estate collateral. For example, is the premium going to come due at a time when it is possible that, due to slowed loan payments, the borrower may not have the money to pay the premium? What is the notice period to the lender prior to the insurance company cancelling the insurance policy? How much may the lender have to be prepared to advance to keep the insurance current if the borrower fails to do so? This assessment of insurance costs will be helpful to the lender in determining how much of a budget may be required to cover certain necessary operating costs of the property if the loan goes into default and the borrower claims it is unable to make payments of any operating expenses.

In Florida, ad valorem real estate taxes have priority over any recorded first lender mortgage; the lender's title policy will always show ad valorem real estate taxes as an exception to title. Because the failure to pay real estate taxes not only results in issuance of a tax sale certificate that includes penalties and interest for redemption once the taxes are paid, but also could lead to issuance of a tax deed so that some third party may acquire title to the lender's real estate collateral without obligation to pay the mortgage, it is very important that the lender's asset management team make sure that the lender's information is provided to the applicable property appraiser's office so that all notices of publication and matters relating to payment of any unpaid taxes are delivered to the lender.

Retail, Hotel and Office Properties

With retail, hotel and office properties that have ongoing tenants, income and operation expenses, the lender should make sure that its files are current and updated with respect to tenant leases, service contracts, management contracts, operating statements, rent rolls, security deposits and similar operational information that will be necessary to have in the lender's possession if the loan goes into default. After closing, there often are different or additional service contracts, management agreements and new leases that are not forwarded to the lender, even though the loan documents require such information. It could be the lender's portfolio management team made a demand but no response was timely provided, and that during this follow-up period the loan's status is beginning to change. It is especially important to make sure that all leases and rent rolls are current including security deposit information. One reason is possible future ownership of the asset; another is that if a foreclosure action will be filed, the lender will need to know who all the tenants are, and whether or not their lease is subordinate to the recorded lender mortgage (only junior interests may be foreclosed). Furthermore, there may be subordination, non-disturbance and attornment agreements that preclude the joinder of certain tenants, and perhaps some of these agreements were either post-closing items or first arose after closing. It is best to gather all of this information before it is time-critical for review by the lender and its counsel.

The following is a checklist summary of the information discussed above:

Due Diligence Real Estate Asset Management Checklist

1. ____ Review status of pending, applied-for land use approvals, including development orders, zoning-variances, rezoning or special exceptions, site plans, plats
2. ____ Review status of approved land use approvals with expiration dates and what may be required to keep those approvals active
3. ____ Review status of pending, applied-for permits for site work, building, construction, environmental, water management
4. ____ Review status of approved permits for site work, building, construction, environmental, or water management with respect to expiration dates due to failure to commence work under the permits, or work stoppage under the permits
5. ____ Review title search for liens and encumbrances recorded against the property
6. ____ Review loan closing documents for assignment of contractor documents and consents to assignment from contractors
7. ____ Determine if any letters of credit are in loan file; review status and issuing bank, and conform to name of current lender
8. ____ Regarding condominium properties, review status of sales, pending litigation, property management and service contracts, leases, condominium association assessments and documents
9. ____ Regarding insurance, review status of property and commercial liability policies, renewal dates and time frame for notices of cancellation for non-payment; confirm renewal payment premiums if to be paid by lender
10. ____ Regarding real estate taxes for Florida properties, check status of payment of taxes, and whether tax certificates and/or tax deeds have been issued
11. ____ Regarding hotels, retail and office properties, review rent rolls, security deposits, operating statements, leases, SNDA agreements, service contracts

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.