Blind Loans: What You Don’t Know Can Hurt You
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 looking to borrow. Interest rates remain historically low. Pressure continues to mount to lower borrowing costs to attract new customers.
Commercial real estate loans are no exception. Banks and other commercial lenders are fighting for borrowers, and on the issue of cutting costs, many are placing more responsibility for documenting commercial real estate loans on loan processors with limited knowledge of the fundamental risks involved. An unfortunate consequence is that many lenders “lend blind.”
What is “blind loans”? Blind lending approaches commercial real estate lending with substantially the same approach as residential homeowner lending. 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 blindly is turning a blind eye to important legal, environmental, and land use issues uniquely applicable to commercial real estate and ignoring available techniques to shift risk 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 loans are not the same as residential real estate loans. Many lenders facing customer resistance to higher borrowing costs may want to turn a blind eye to this reality. Ignoring this reality, however, does not change it. Ignoring this reality may seem on the surface to reduce costs, but it can jeopardize bank profits and jeopardize capital.
“Sound and secure credit practices” is not just a phrase used by banking regulators. It should be a way of doing business.
Not focusing on the genuine risks that commercial real estate loans present is not a sound and safe lending practice.
Believing that a commercial real estate loan is properly documented through the use of computer-generated pre-packaged loan documents, without also requiring a qualified and in-depth analysis of land use controls imposed by registration and zoning documents, informed examination of survey, lease subordination, insurance, access, borrower authority, and other legal issues, and without fully understanding the environmental risks posed by existing, former, or anticipated adjacent tenants, occupants, and owners of land, you are failing to follow sound credit practices and safe.
Blindly following a loan document checklist 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 that documents can raise, is not follow solid and safe loans. practices Using the ostrich approach to lending is a game of Russian roulette. The result can be catastrophic for the bank’s profits and capital if and when the loan fails.
Banks and other commercial lenders that follow these unsound and unsafe banking practices don’t 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 internal 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 be beyond the documents.
A perfectly generated set of “standard loan documents” can be of little value if it does not adequately address the unique issues raised by the commercial real estate project it serves as collateral. Without a doubt, every commercial real estate project is different. Unlike owner-occupied residential real estate, commercial real estate collateral cannot be safely “presumed” to be legally adequate, or even legally usable for its intended use.
A beautifully drafted mortgage on commercial real estate is of little value if the project does not have a commercially reasonable legal right of access or parking.
CASE POINT: How safe is a loan on a banquet hall for 800 people in a mixed-use facility if the banquet hall has the legal right to park only 155 cars?
CASE POINT: What is the collateral value of a hotel at a highly visible road junction, with as its primary means of access 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 the lender with specialized commercial endorsements is a useful method of taking risk away from the lender, but the lender must understand how to interpret each endorsement to know what it insures.
CASE POINT: While attending a loan closing as an “accommodation” for a lender to make a large loan to one of his “best customers” to purchase a warehouse and manufacturing building, with instructions from the lender to simply “supervise the execution of the closing documents”. (lender had prepared) and approve 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 Endorsement The ALTA 3.1 Zoning Agreement to be attached to the loan policy revealed 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, did not understand its meaning. The transaction was aborted by the remorseful but grateful borrower, who would not have been able to operate his business if the transaction had proceeded. If this restriction were not recognized prior to financing, it would almost certainly have meant the bankruptcy of one of the “best customers” of the bank and a huge non-performing loan for the lender.
Experience shows that lenders should not assume that borrowers and their attorneys will always conduct adequate due diligence to determine all associated risks that may affect the project and important underlying assumptions for a loan.
A lender should also avoid the trap of relying too heavily 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 STUDY: A mortgage securing a loan of $1,650,000 contained a guarantee from the borrower that “all leases encumbering the Real Property 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 a Lessee Option to purchase the entire strip center for $1,520,000. Will declaring a breach of warranty default fix this defect? What is the collateral position of the lender if the Lessee exercises the Purchase Option on him?
The lending business is all about making strong, secure loans that perform profitably as planned. Performance is the key. Not foreclosure. The ability to declare a default and initiate enforcement and enforcement proceedings is a last resort. It is not a viable substitute for diligent evaluation of the material predicates of the loan and will rarely fix problems with the underlying collateral.
Strong and secure loans require a comprehensive understanding of all the relevant issues facing each commercial real estate project that serves as collateral. If lenders are going to make commercial real estate loans, they must follow sound and safe lending practices. To do this, they must learn to fully and meaningfully assess all risks associated with their collateral, or retain an attorney 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 the limitations of many well meaning but unaware in-house loan processors is not a sound or safe lending practice.
Independent, focused and knowledgeable lender due diligence is a must.
