COVER STORY, MARCH 2008

LENDERS BEWARE
The project influence rule and other legal intricacies can affect lending in redevelopment areas.
Martin L. Borosko, Esq. and Michael A. Oxman, Esq.

Borosko

Lending in redevelopment areas presents a unique set of challenges. One of the biggest and most often overlooked challenges is valuing the property. On many occasions, lenders fail to appreciate the legal intricacies affecting property values in redevelopment areas. The result is a loan that far exceeds the “legal value” of the property and a lender left scrambling to try to recoup the outstanding funds from a landowner.

To avoid that dubious proposition, lenders must be sure to conduct proper due diligence. The first step to conducting proper due diligence is making sure to identify when a property is in a redevelopment area. Far too often, lenders fail to recognize that a property is in a redevelopment area and, therefore, fail to conduct the due diligence necessary to make an informed lending decision. A few simple changes to a lenders’ shelf documents, in particular the loan application and due diligence checklists, can help avoid this important mistake.

Oxman

Once a lender determines that a property is in a redevelopment area, it must assess how that fact might impact the value of the property. To do so, the lender must answer a number of complex legal questions including but not limited to whether: (1) the property is in “an area in need of redevelopment” or “an area in need of rehabilitation,” (2) the property is subject to condemnation, (3) the redevelopment plan supersedes existing zoning or serves merely as an overlay for existing zoning, and (4) the redevelopment plan and redevelopment agreement permit the applicant to develop the property.

To answer these questions, the lender must request as part of its due diligence the production of the legal documents governing the redevelopment efforts for that area. Obtaining the right documents and understanding those documents is essential.

Understanding the Project Influence Rule

When a property is subject to condemnation and restrictions against development, the issue of valuation becomes particularly complex and is controlled by a frequently forgotten and misunderstood doctrine of law — known as the project influence rule. In 1976, this issue was at the heart of New Jersey Sports And Exposition Authority v. Giant Realty Associates case. The project influence rule states that governmental action such as the announcement of a redevelopment project can neither serve to increase nor decrease the compensation to be paid to a landowner whose property is subject to condemnation. Instead, land values are “frozen” at the time an event occurs, which causes a significant fluctuation in value of the condemned parcel. In this way the condemnee is protected “from a decrease in value of its property which is attributable to the cloud of condemnation placed upon the property by the condemnor” where, for example, an area is declared in need of redevelopment. By the same token, the condemnor is insulated “from the ravages of an inflationary spiral” that may occur as a result of land speculation, which often accompanies some planned redevelopment. 

An Example of Project Influence at Work

Ignorance of the project influence rule can have a very real impact on a lender. A clear example is a case in which a New Jersey city announces that it has reached an agreement with a developer on a 15-year plan to redevelop its downtown and several adjacent neighborhoods into a mixed-use community. The announcement sparks tremendous new interest and speculation in the area and land values rise tremendously over the next several years. Two years into this inflationary spiral, an established restaurateur from New York City seeks to open a restaurant. He decides that instead of renting a spot, he will purchase a commercial property to house his new restaurant.

Although the restaurateur is aware that the property is in a redevelopment area and that the property may one day be acquired by condemnation for the redevelopment, he is not aware of the project influence rule. As far as he is concerned, he wishes to go through with the transaction under the assumption that his property may never be acquired, or, in the worst case scenario, he will simply be bought out by the redeveloper at or above his purchase price in a steady or rising market.

As is too often the case, the prospective lender for this property is also unaware of the project influence rule or the fact that this property is even in a redevelopment area at all. Instead, the lender analyzes whether this property can support the businessman’s loan request by valuing the property in the traditional method of appraising the property by comparing recent sales of similar properties in the area and reaching a conclusion of value. In this example, the lender finds that $1 million for this property is in line with other similar properties in the area and approves the loan.

In this example, disregard of the project influence rule will have dire consequences for both the lender and the restaurateur when this property is taken for condemnation. The condemnor will factor out the positive influence that the announcement of the project had on property values in the area. Using a study conducted by an experienced appraiser, the condemnor will determine that the true and “legal” value, i.e., the value after factoring out the project influence, of the subject property for condemnation purposes is actually only $500,000, half of what the lender had previously determined.

The lender, no doubt already stressed by the current market environment of the sub-prime and credit crises, learns that it has lent money to an owner far in excess of the property’s “legal” value and can no longer look to the landowner’s condemnation award to recoup its loss. The lender must now take a loss on this property and spend additional monies on legal proceedings to try and recoup the outstanding funds from the landowner.

The above is not an abstract problem. The example uses a commercial property, but the same scenario can and often does play out in residential properties as well. There are quite a few real world examples in which a bank has either lent money or refinanced a mortgage based upon an appraisal that failed to take into account the project influence rule. In each case, the result has been the same — a lender exposed to a potential material loss. Lenders can avoid this potential exposure by understanding and undertaking the due diligence necessary to assess the impact that a redevelopment effort may have upon a property located in the redevelopment area.

Martin Borosko is the managing member of the Livingston, N.J.-based law firm Becker Meisel LLC, and Michael Oxman is a senior associate in the firm’s real estate and construction practice group.

©2008 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.