Five Considerations to Limit Real Estate Lending Risk
Updated: Nov 10, 2021
Capital lending sources for real estate - banks, credit unions, family offices and other private lending organizations - take on varying risks as they compete with each other on the speed and ease of providing funding. Different capital sources will have different risk appetites for basic underwriting criteria. All of them should have a good understanding of the catastrophe risk of the location of the real estate including high hazard locations prone to flooding, wildfire, earthquake and weather events such as hurricanes and tornados. There are, however, five additional considerations in insuring risks that capital funding sources should always address to protect their investment.
Lenders should require the Borrower to purchase expansive property coverage - The most comprehensive form of property insurance is special form or so called “all risk” property insurance. Special Form property insurance covers all perils, unless specifically excluded within the policy. This is in contrast to basic and broad form property policies which cover only perils that are specifically articulated in the policy.
The property insurance should require insurance up to replacement cost, without deduction for depreciation, including replacing the damaged property with materials of like kind and quality. Lenders should require that a licensed appraiser calculate the amount of funds needed to replace the property at current replacement cost value. In addition, for all income property, the Borrower’s insurance policy should cover for loss of rental income to assure that if the property is temporarily uninhabitable, the Borrower is able to receive indemnification for lost rent. The amount of coverage required for lost rental income should be based on a full year’s income, or a greater amount if reconstruction following a total loss would take more than one year.
To properly protect Lenders’ rights, the Lender should be named as a mortgagee on the property insurance coverage. In the case of a loss, this will protect the Lender’s financial interest in any insurance payout or settlement to the Borrower.
Lenders should require adequate liability insurance. Liability insurance protects against claims resulting from personal injuries and damage to other people or property (3rd party claims). If there is a third-party claim and the Borrower becomes insolvent, this can negatively affect the Borrower’s ability to make future loan payments. Accordingly, Lenders should also require that they be included as an additional insured on the liability policy in case they should be held legally responsible for a claim caused by the Borrower.
Finally, Lender requirements should require that the Borrower’s insurance include advance written notice of cancellation not just to the policy holder, but to the Lender as well. This will allow the Lender to ensure there is adequate insurance on the property through the life of the loan, and provide the time needed to enact “forced placed” coverage if the Borrower does not place new coverage after the cancellation. Standard property insurance mortgagee clauses will typically provide for advance written cancellation notice to the Lender but care must be taken to require such notice to liability insurance additional insureds.
Prudent Lenders who pay attention to these contract insurance requirements will have better performance in their lending portfolio and greater success in the secondary markets.