Use a step-by-step approach to review and analyze a property’s discretionary entitlements before approving a loan on the property.
If you work in the real estate industry, you have no doubt heard the term “caveat emptor.” It means “let the buyer beware.” But have you ever heard of “let the lender beware”?
To understand it, we need some historical perspective.
In the lending industry, that takes us back to the Medici Bank of Florence, Italy, founded in 1397. At that time, private lenders recognized the caution to “beware” of those who sought to borrow their money. The Medici family invented the accounting concept of double-entry bookkeeping known as debits and credits that is still used to this day as a means of “checks and balances” to ensure that errors in their records could be avoided.
To fully understand the elements of the loan request submitted to them, the Medici family, as Europe’s wealthiest private lender, developed loan underwriting systems and procedures that have evolved into what today we commonly refer to as “due diligence.”
Simply put, due diligence equates to the skill and process of “comprehensive understanding.” Fast forward to 2022, and today’s private lenders need not only to fully understand the asset that will be the subject of the loan being contemplated but also to know the background and experience of the prospective borrower. Failures or deficiencies in due diligence on either the asset or the borrower can and will open the door to the fate of the Medici Bank, which liquidated in 1494.
As Winston Churchill wrote: “Those that fail to learn from history are doomed to repeat it.”
What Are Entitlements?
The due diligence process begins once a loan application has been submitted and the private lender’s underwriting team has initially reviewed it. Following that initial evaluation, an interview with the borrower and their team is set up with the lender and their underwriting team to “hear the story” of the borrower and the project.
Following that interview, the private lender typically sends the borrower a list of due diligence documents that must be submitted for review and analysis. In the world of acquisition and construction loans for either commercial or residential development projects, one of the most critical elements of the due diligence process is the underwriting team’s verification of the “Status of Entitlements.”
In the real estate development industry, the term “entitlements” refers to the approvals given by a governing body, either a municipality or county that has authority over what can and cannot be built within their jurisdiction. Although the exact rules and regulations are different in every state and local jurisdiction across the country, it’s safe to say that each one has its own rules and regulations that grant development rights.
These “development rights” are referred to as “entitlements.” In other words, the approval granted “entitles” the property owner to do X, Y, or Z on their property.
In addition to the review of entitlement documents the borrower provides to the private lender, the underwriting team should first review, in detail, the “Entitlement Conditions of Approval,” with a focus on the expiration period of the entitlement approvals.
The underwriting team should then conduct either in-person or online interviews with the appropriate members of the municipality’s departmental staffs, including the planning department, the public works department, traffic department, and so on.
Based on the confirmation of questions and issues from those municipal departments, the underwriting team must then evaluate the “conditions of approval” relative to their costs and timeframes as they impact the project’s development plan. Then they must incorporate those costs and timeframes into the loan budget and terms to ensure the loan is adequate to enable the conditions of approval to be met by an assessment of the source and use of funds in the loan.
Before a private lender approves a loan on the property in question, a review and analysis of the status of discretionary entitlements must be completed. All codes, approvals, and conditions of approval must be included in the analysis. The primary objective is to ascertain if all discretionary approvals by municipal agencies have been acquired and that agreements exist that provide reasonable guarantees the approvals will remain with the property.
A search of public records is required to validate that all representations by seller, engineer, and municipal personnel reflect the actual approvals received. The building rights provided by municipal approvals are instrumental in determining the property’s value, and their existence and survivability must be evaluated in determining the suitability of providing a loan for the property.
A Step-By-Step Approach
The private lender’s underwriting team should follow the due diligence steps below and incorporate them into their loan underwriting report before making a decision about the loan application.
- Determine jurisdictions for approvals on land and development (county or city, state agencies, public utilities, etc.). If the property is in a county, identify which city’s sphere of influence covers the property. Evaluate whether it can it be annexed to a city.
- Obtain copies of the following: Tentative Map Conditions of Approval, Development Agreement, Improvement Agreements, CC&R’s Zoning Code, Environmental Impact Report, Negative Declaration, etc. Review and examine all restrictions and, for each condition, the timeframe and the stage of development when condition must be met. Determine which conditions have been satisfied, and highlight any conditions required for the current status that have not been met.
- Review all plans, municipal minutes, and documents to determine which approvals have been received. Analyze the information and decide whether any remaining approvals require a discretionary approvals process. Summarize all approvals required to obtain building rights and construct on the property. Identify the status of approval for each.
NOTE: The procedures enumerated on the following pages provide only general guidance for the examination of entitlements on the property. The components of the report will vary from property to property. In all cases, the procedures performed should identify and explain the approvals required and received. - Verify whether a tentative or final map exists on the property.
a. If tentative, when does it expire?
b. If final, when do bonds and agreements expire? - Examine escrow and purchase instructions. Determine which approvals are contingencies in escrow. Delineate the status of these approvals and, if not yet received, when they are expected to be approved.
- Outline all building and development restrictions, such as:
a. Building restrictions.
b. Architectural restrictions.
c. Lot size restrictions, setback requirements.
d. Any pending moratoriums or development limitations.
e. Whether any prescriptive easements appear to be on the property.
f. Any obligation to grant additional easements.
g. Public or private rights of way.
h. Easements and rights of way requiring access for utilities and drainage.
i. Other restrictions. - Identify the document where restrictions are found. Evaluate wheher restrictions can be amended or removed and, if not, whether they cause problems in development.
For any easements or rights of way that exist, trace easements to the map of the property. For each easement listed, perform the following:
a. Obtain a copy of the recorded easement.
b. Trace to the map of the property.
c. Determine whether the easement poses any problems in development of the property.
d. Describe the nature of the rights of way (i.e., if roads, are they improved, can they be vacated or moved, etc.?).
e. Determine whether easements or rights of way are needed to provide access for utilities and drainage. If so, what is required to obtain (i.e., acquire through eminent domain, at what cost, etc.)? - Ascertain the documents and agreements that provide the development rights.
a. Is there a development agreement? What is the governing body? Determine what the rights and obligations are.
b. Is there a vesting tentative map? If so, what are the rights and obligations? - Delineate the services provided by the local entity (e.g., police, fire, fire insurance rating, trash pickup). Is the developer required to provide any municipal facilities or maintenance services?
- Review local jurisdictions as to the local attitude toward new development.
a. Governing body.
b. Local citizens.
c. Is there a growth management plan?
d. Are there any proposed growth initiatives (governing body initiated or voter-initiated)? - Evaluate process and requirements for construction. List and describe.
a. Is a homeowner’s association required?
b. Is there an architectural committee? Local citizens?
c. Have you obtained all relevant ordinances?
• Subdivision
• Building
• Park dedication
• Underground
• Zoning
• Solar
• Sprinkler requirements
• Uniform Building Code (What year? Local amendments?)
d. Are there any unusual or unduly expensive local requirements? - Interview the local building department regarding status and requirements for the property. Person talked with: __________
- Evaluate project bonding requirements. Does the governing body require subdivision bonds? Will they accept cash? Will they accept a lender’s agreement in lieu of bond? Must lender be local or a special type? Will the governing body allow reasonable partial releases of subdivision collateral as work progresses?
- Outline zoning and requirements: General plan zoning, present zoning, potential zoning changes. If GPA is necessary, when may city process an amendment? Will there be resistance to rezoning or GPA from neighbors or the governing body? Is there a specific plan for the area? Are there any affordable housing requirements? Are there any credits available? Cost?
- Interview the local planning department regarding status and requirements for the property. Person talked with:
- Interview the local engineering department regarding status and requirements for the property. Person talked with: . Is land subject to traffic generation levels? Fees/costs?
- Review for any special considerations. Is land in a designated redevelopment area? Can we get special zoning, financing, or expediting? Is land in Coastal Zone, subject to Coastal Commission? Is any part of land in a geologically hazardous area? What portion or percentage? Is land being considered for: park? school? freeway? other public use?
Will we receive credit toward open space requirements for our recreational facilities? Is land in any special zone, such as national forest, wildlife preserve, fire hazard area, earthquake fault zone, designated flood area, hazardous dump site, nuclear power plant, Basic Emergency Planning Zone?
Has any portion of the land been classified as a historic landmark, or historically or archaeologically significant site? If not, are there any structures, other physical features, or locations on the land known or believed to have historical significance that could block future development)?
Are there any trees or ecologically sensitive areas that may affect development of the area? Will the city require donation of land or cash or cash in lieu of land for open space, parks, schools, sewers, or recreation? - Determine name(s) of school district. Is there a school impaction problem? Has an impaction fee or other school fees or credits been established? How much? If not, is one under consideration? How much? Are existing facilities permanent or temporary? If temporary, source of funding for permanent facilities?
- Evaluate subdivision process and prepare a timetable and critical path schedule:
• How long to receive approval of tentative map?
• How long to have map ready to record?
• How long for rezoning?
• How long for General Plan Amendment?
• How long for annexation?
• Other subdivision factors to be considered? - Summarize the findings, describing all pertinent information obtained. An opinion must be prepared regarding the status of entitlements on the property and the guarantee they will remain in place.
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