Question Everything? What Happens When Exemptions Disappear

You’ve just closed a loan for a residential conversion of a commercial property.  The LTV is on target and the DCR is sound. Then you pick up the paper and read an article like this, detailing how the residential-only property isn’t actually eligible for the mixed-use real estate tax exemption it was granted.

This is in many ways a nightmare scenario for any lender (including at least one CDFI that financed some of the properties in question): you have done your due diligence, requiring proof of approval for the exemption that makes the project viable, and now it turns out that the exemption was granted in error and will be rescinded.  What are the next steps?

• Look Backward: This step may come later, but in any workout a lender should review what happened to see if such crises can be prevented in the future.  In my last post, I reminded readers to verify subsidy program requirements independently.  But should an underwriter really be expected to verify the validity of a real estate tax exemption already approved by the city?  Does the underwriter need to question everything?  Perhaps not, but then again, it would take seconds to Google the source of the exemption, and the last line of the first hit would point you to the crucial distinction:

This search could have prompted questions from the underwriter regarding why the residential use conversion was eligible.  It is very possible that the in-hand approval still would have won the argument, but this would have given the lender one more chance to avoid becoming victim to the city’s mistake.

• Look Forward: When an issue like this surfaces, it is critical to be proactive in your response.  The city made a mistake, and now has to figure out how to correct it.  You and your borrower should both be at the table for that discussion, advocating for a fair approach that recognizes that investment decisions were made based on the city’s misstep. 
• Pat Yourself on the Back: Perhaps due diligence didn’t go quite as far as it could have, but you still may be in good position because you are actively monitoring your portfolio and the markets you serve, so you were the first to hear about the issue.  You have maintained excellent relationships with your borrower, so they are likely to do what they can to ensure that you are made whole in the end.  You are also in good standing with local politicians, giving you a better chance of convincing them that city hall needs to limit the collateral damage of its mistake.

Even good underwriting can be undermined by surprises like this.  Thankfully, this specific scenario is rare, but it should provide a strong reminder to go the extra mile in your underwriting, monitor your portfolio and lending markets diligently, and maintain excellent relationships with your borrowers and local government.

In community development, nothing is a sure thing.  Except, that is, excellent service from High Impact.
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