Lender Due Diligence Requirements Not Easing Yet

By Jenny Redlin, Principal, Partner Engineering & Science Inc.: In the climate of intense regulatory scrutiny and risk aversion over the last few years, many of our lender clients have tightened, or adopted for the first time, their policies on managing environmental and physical risks of lending on commercial and multi-family properties.

As noted in a recent Economy Watch column, the Federal Reserve reported in an April “Senior Loan Officer Opinion Survey on Bank Lending Practices” that domestic banks are, on average, easing standards on commercial and industrial lending.  Though this may be true for some aspects of lending, it does not seem to be the case for the physical due diligence standards for managing environmental and engineering risks in commercial real estate lending.     

In the climate of intense regulatory scrutiny and risk aversion over the last few years, many of our lender clients have tightened, or adopted for the first time, their policies on managing environmental and physical risks of lending on commercial and multi-family properties.  We have assisted a number of large lending institutions in writing such policies.  This often takes the form of a decision matrix, based on a combination of the loan size, collateral property type and location, that determines  when to require a Phase I Environmental Site Assessment, Property Condition Report, Seismic Risk Assessment, other less comprehensive due diligence report, or no report at all.

This trend doesn’t seem to be letting up, as indicated in recent quarterly surveys of lending institutions by Environmental Data Resources (EDR) Insight.  For most of the nation’s largest lenders, environmental and engineering risk management policies have long been in place but many are reviewing and updating these policies to better screen for high-risk properties, or to account for “newer” risks as vapor intrusion.  Others are simply enforcing stricter adherence to their existing policies as a reaction to being burned from high-risk properties slipping through the cracks, with “virtually no respondents indicating much relaxation in underwriting standards over the past quarter,” according to the survey results.  One mid-size institution’s risk manager was quoted as saying “There’s a sense that these deals have to be whiter than white for us to touch them.  No one wants to take on risk yet.”  As EDR Insight reports, more community banks are also adopting environmental policies for the first time.

On the multi-family front, Freddie Mac recently updated its seismic risk policy, and is lately requiring stricter adherence to their standards for engineering and environmental property inspectors out of concern that unqualified professionals were not adequately characterizing property conditions and risk.  Additionally, EDR Insight reports that Fannie Mae and Freddie Mac have ramped up scrutiny of the mortgages sold to them, resulting in increased loan ineligibility and repurchase risk for lenders.

Investors seeking financing (and their brokers) should understand the physical due diligence requirements of their potential lenders in order to find a lending partner that will fit their needs.  Some lenders will no longer finance certain high-risk properties, such as gas stations and dry cleaners (due to high potential for contamination) or unreinforced masonry buildings (which perform poorly during earthquakes).  This understanding will also ensure that the right level of due diligence is performed, which will help avoid delays to closing. 

Many have speculated whether, as the industry heats back up, due diligence standards will loosen again back to the level of the go-go days.  While new loan originations are increasing, the order of the day still seems to be tight -risk management practices.