Best Practices: Evaluating the Risk of Real Estate Encroachments

When U.S. Small Business Administration (“SBA”) loan proceeds are used to finance the acquisition of commercial real estate, a title policy is obtained to protect the interests of the bank and the borrower. During the loan due diligence phase, the bank must thoroughly review exceptions that appear on the title commitment and survey, if available, that may present a potential risk to both the bank and the borrower. One such exception pertains to real estate encroachments.

One common encroachment issue that comes up in a real estate transaction occurs when a building, a driveway, a parking space, or part of some structure erected on the property extends onto the property of another parcel of land, public street, or an easement. Encroachment issues shouldn’t be ignored and should be resolved prior to the closing of the loan to avoid potential post-closing issues problems during the servicing of the loan. The relevant parties should analyze the encroachment and assess the risk of the encroachment and how such risk can be mitigated.

If a survey or a title commitment identifies an encroachment issue on the property to be financed through an SBA loan, the bank should consider whether this encroachment will have an adverse impact on the value of the real estate, borrower’s business, borrower’s ability to repay the SBA loan, and any potential liquidation issues in the event of borrower’s default. As such, when analyzing the risk pertaining to encroachments, the bank should assess – at minimum – the following factors: (1) the type of encroachment (e.g., chain-link fence, building, elevated sign, etc.); (2) the extent of encroachment; (3) any adverse impact to the value of real estate; (4) any adverse impact to borrower’s business; (5) any effect on potential to develop or use the property; and (6) compliance with zoning and use regulations.

By way of example, a structure such as a chain-link fence that can easily be moved, or removed, is much easier to rectify as opposed to a building that’s affixed to the realty and encroaches onto someone else’s land. Furthermore, it’s also important to understand whether the extent of encroachment is inches, feet, or yards since the risk to the bank and the borrower will increase depending on the extent of encroachment. Next, the bank should consider whether the value of the real estate will decrease if the encroaching structure is removed. If the encroaching structure is an integral part of the real estate, then the value of said real estate may decrease once the encroachment is rectified. This will have a trickle-down effect with respect to bank’s collateral analysis, purchase price of the real estate and the use of proceeds of the loan. Lastly, in the event the borrower needs to rectify the encroachment post-closing, this could potentially mean an interruption to borrower’s business, which may have an adverse impact on borrower’s cashflow. As such, the bank must consider any adverse impact to borrower’s business operation that may affect borrower’s ability to repay the loan.

It’s important to note that the list of factors above is not exhaustive since the facts and circumstances differ depending on the type of encroachment. As such, it is always best to discuss specific details with counsel to avoid any post-closing complications. For further assistance please contact the attorneys at Starfield & Smith, P.C. at 215-542-7070 or email us at info@starfieldsmith.com.