New Jersey, like the rest of the country, has seen a significant slowdown in commercial real estate (CRE) lending over the last two years, in large part due to rising interest rates. However, with over $2 trillion in commercial mortgage loans slated to mature between 2024 and 2027 and recent indications from the Federal Reserve that rate cuts are forthcoming, there could be an unprecedented number of refinances and sales of real estate assets on the horizon.
While the precise timing of the anticipated deal resurgence is anyone’s guess, the eventual influx of new CRE loans will lead to a substantial amount of due diligence on both new and existing real estate collateral.
Due diligence for CRE loans involves a comprehensive review and analysis of the various conditions and risks associated with the property being mortgaged, with the goal of mitigating such risks to the greatest possible extent before closing the loan. Navigating the due diligence process is typically a combined effort of the lender, the borrower, each party’s attorneys, and the borrower’s title company. The extent of due diligence varies depending on the specific facts and circumstances of the loan and the property, but it almost always consists of an examination of the title report, survey, lease agreements, property insurance certificates, land use and zoning approvals, environmental reports, and any other documents pertaining to the property, as well as the organizational documents of the borrower and guarantor entities. The following is an overview of the most important due diligence components.
Title
Virtually any lender making a CRE loan will require a lender’s title insurance policy, which insures the validity, enforceability and priority of the lender’s lien on the property. Accordingly, it is essential for lenders and their counsel to review a current title insurance commitment.
As soon as the lender has committed to making the loan, the borrower or its attorney should order a title commitment from a title company licensed to conduct business in New Jersey. The lender should also ensure that the borrower’s attorney has ordered various searches relating to the property, including flood hazard and tidelands searches, property tax searches, and judgment, franchise tax, and Patriot Act searches on the borrowers and guarantors. These searches should also be included on the closing checklist (more on the checklist later).
The title commitment contains three primary schedules: Schedule A, Schedule B-I, and Schedule B-II. Schedule A sets the stage for the entire commitment. It identifies the proposed insured (owner and lender), the amount of the policy, and the type of ownership interest (e.g., fee simple). In addition, Schedule A often provides the metes and bounds description of the property (though it is sometimes found in a separate Schedule C).
Schedule B-I sets forth all of the title company’s requirements that must be satisfied before issuing the title policy, such as the payment of taxes and assessments, the satisfaction and release of any existing mortgages and other liens, and the execution and recording of the new deed (if applicable) and mortgage.
Schedule B-II sets forth a list of exceptions—items that will not be insured under the title policy. This includes both “standard” or “permitted” exceptions and “non-permitted” exceptions. Standard exceptions include easements, rights of way, restrictive covenants, licenses, leases, subordinations, and other documents of record, which are usually voluntarily imposed by and/or known to the current owner or its predecessor in title. While these exceptions do not need to be eliminated for the title policy to be issued, they should be carefully reviewed by the lender’s counsel, in conjunction with the survey, to ensure they do not prevent or interfere with the borrower’s intended use or development of the property. Another standard exception is the survey exception—which specifically excepts from coverage “any discrepancies or conflicts in boundary lines or shortage in area or encroachments, which a correct survey or any inspection of the premises would disclose.” This can be removed by issuing a Survey Endorsement (ALTA 10.5) (if an accurate survey is obtained), or, in the case of a lender’s policy only, a “No Survey” Survey Endorsement (ALTA 10.15).
Any non-permitted exceptions, on the other hand, must be cleared for title to be insurable. They typically consist of mortgages, judgments, lis pendens, tax liens, environmental liens, construction liens, UCC-1s, and breaks in the chain of title. While existing mortgages are generally paid off at closing (and omitted as an exception at that time), the removal of other non-permitted exceptions may require negotiation with the title company, and the clearing of these items often necessitate a waiver, release, indemnification, or other document satisfactory to the title underwriter.
Some exceptions, such as the survey exception, may be omitted through the issuance of endorsements. In New Jersey, standard endorsements, including the Survey Endorsement, are included at no additional cost to the borrower. However, additional endorsements could be required in certain transactions. For example, lenders may look for an Encroachment Endorsement (ALTA 28.1) to cover any losses caused by any encroachments upon the existing buildings on the property. The Swap Endorsement (ALTA 29) is added to loan policies involving interest rate swaps and insures against invalidity, enforceability, and priority of the mortgage as security for the repayment of the swap obligation.
Survey
Another critical part of due diligence is the survey. The lender should ask the borrower to provide a current survey of the property, which should (1) be certified to the lender, (2) include a metes and bounds description of the property that matches the legal description set forth in the title commitment, (3) identify all buildings and other improvements on the property, and (4) confirm that the property has legal access to a public road. In circumstances where the lender needs additional coverage beyond what is included in the standard lender’s policy, the title company will likely require that the survey be prepared in accordance with the 2021 standards issued by the American Land Title Association and National Society of Professional Surveyors (also known as an ALTA Survey). The ALTA Survey is more detailed than an ordinary “boundary” survey and requires a comprehensive review of the title report by the surveyor to ensure that all easements, rights of way, and other items described in Schedule B-II of the title commitment are plotted.
Leases
The lender should request copies of all commercial leases affecting the property. Since payment of debt service on most CRE loans is tied to the rental income generated from leases, it is good practice for lenders and their counsel to scrutinize any lease provisions which could relieve or impact the obligation of the tenant to pay rent, such as abatements, setoffs, and termination rights. Other key provisions that should be reviewed include subordination clauses (to ensure the lease is subordinated to the lender’s mortgage) and provisions relating to renewal options, term lengths, and tenant purchase rights (including rights of first refusal).
In addition, lenders and their counsel should be sure to review leases for compliance with New Jersey’s newly promulgated flood risk disclosure requirements. The New Jersey Flood Risk Notification Law (the NJ Flood Law)mandates that, effective March 20, 2024, landlords are to make specific disclosures to their tenants relating to flood hazards on the leased property. Failure by the landlord to comply with the NJ Flood Law could result in the tenant terminating the lease, recovering prepaid rent, and seeking other damages available at law. Accordingly, all leases and lease renewals executed on or after March 20, 2024 should contain the required disclosures.
Insurance
Lenders must ensure that the borrower has secured appropriate insurance covering all real and personal property that is part of the lender’s collateral, and that such insurance is extended to the lender. As a condition to closing the loan, the borrower should provide insurance certificates as proof that it has secured insurance policies which comply with the lender’s insurance requirements as described in the loan documents (note: most lenders will accept insurance certificates for purposes of closing, but the full policies, with any required endorsements, should be obtained when available). There are two standard insurance certificates that should be included on the closing checklist: the ACORD 25 (Certificate of Liability Insurance) and the ACORD 28 (Evidence of Property Insurance). The ACORD 25 must name the lender as a “Certificate Holder” and include language stating that the lender is an “Additional Insured,” In the ACORD 28, the lender should be marked as a “Mortgagee” and “Lender Loss Payee.”
Practical Considerations
From a practical perspective, CRE due diligence is all about staying organized. The most effective tool for tracking the various due diligence items is the due diligence checklist. At the outset of every deal, the lender’s attorney should create a specifically tailored checklist and distribute it to all parties and their attorneys. The checklist is the authoritative document of the transaction. It should be updated and redistributed by the lender’s attorney as often as possible, with specific notations for matters requiring the parties’ attention or discussion (this is where the role of the paralegal is crucial; as every real estate lawyer knows, excellent paralegal support is the key to a smooth transaction). In addition, the parties and attorneys often benefit from regular conference calls to discuss the status of the various open checklist items. These calls will ensure that all items are being addressed in a timely manner and that any closing day “fire drills” are kept to a minimum.
The above is not an exhaustive list of things to consider when engaging in due diligence, but it hopefully provides a useful framework for navigating the due diligence portion of any CRE transaction involving New Jersey real property, especially as real estate debt costs decrease and transaction activity trends upward.
Reprinted with permission from the April 23, 2024 issue of the New Jersey Law Journal. © 2024 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.