Zoning Issues and Real Estate Refinancings

[This article originally published March 6, 1998.]

Zoning changes over time. This fact presents an important issue in commercial real estate refinancings. If, as a result of zoning changes, a property (use or improvements) no longer complies with current zoning laws, lenders typically require that the borrower demonstrate that the property complied with applicable zoning laws in effect at the time the use or improvements were first started. If this can be established then the improvements are “legally non-conforming” or “grandfathered.” This means that, absent special circumstances, the established use and improvements can continue notwithstanding the fact that they could no longer be constructed if construction started today. For old properties or for properties with multiple structures built over a number of years, establishing historic compliance is no small task.

Because the economics of today’s securitized financings are driven in large part by a property’s income-producing capacity, loan underwriters want to identify and quantify risks of future interruptions in the cash flow stream. This due diligence includes requiring assurances that the improvements being financed can be rebuilt after a fire or casualty. This raises special issues for legally nonconforming structures. Whether a lawfully nonconforming structure can be rebuilt in its present size, shape and location depends on applicable state law and the specific terms of the relevant local zoning ordinance. Some zoning ordinances provide that, upon destruction, the property may be rebuilt to its prior size, shape and location as long as reconstruction is undertaken within a certain specified period of time – typically one year. Other ordinances state that, if more than a specified percentage (usually 50% or more) of the replacement value of the property is destroyed, then any reconstruction must be done in accordance with the terms of the present zoning ordinance. In the event of a casualty, rebuilding in accordance with current zoning may require a significant alteration of the size, shape and location of the improvements which could materially diminish the property’s income producing capacity. Consequently, some lenders are unwilling to provide financing, especially non-recourse financing, for nonconforming structures without special assurances or comfort; sometimes not at all.

In today’s financing environment, owners of older commercial properties must be sensitive to these issues and should be alert to proposed zoning changes. They must be mindful that a proposed zoning change, which if adopted will change a conforming property to a lawful but nonconforming property, may negatively impact the ability to refinance the property in the future. Unfortunately, these issues often surface late in the loan underwriting process–after the owner has spent a substantial amount of time and money toward completing the transaction. Effective, prompt resolution of these issues requires the input of seasoned land use professionals familiar with the motivations and concerns of today’s lenders.

A moderate investment in a team of experienced professionals (attorneys and surveyors) will pay off by making sure your next financing transaction goes smoothly.