Best Practices: Zoning Compliance Letters and Zoning Endorsements

When financing the purchase or construction of commercial real estate, SBA Lenders should confirm that the subject property’s zoning classification allows for the Borrower’s proposed use of the property. If the municipality determines that the Borrower’s property is not zoned properly after the loan closes, the Borrower may face fines, legal battles, or potential forced closure of the property which could jeopardize the Lender’s SBA guaranty.

Lenders may require the Borrower to obtain a zoning letter from the municipality for the subject property to minimize the risk of post-closing zoning issues. At a minimum, the zoning letter should confirm the property’s zoning designation (i.e. commercial, industrial, or mixed-use). Depending on the municipality, the zoning letter may also include information on the following topics:

• Outline of the permitted uses for the property
• Status of any zoning violations
• Zoning variances or exceptions granted for the property
• Zoning classification of adjacent properties
• Setbacks, parking requirements, or conditional uses

Obtaining a zoning letter is particularly important if the Borrower’s intended use of the property differs from the current use. For example, if a Borrower intends to convert a building used for retail sales into a veterinary clinic, the property’s zoning status may need to be changed from commercial to light industrial depending on the municipality’s zoning codes. The zoning letter can provide assurance that the intended use aligns with the zoning regulations prior to the loan closing. While a zoning letter is a useful piece of due diligence, a letter is not ironclad as the Lender will generally be unable to hold the municipality liable if the information in the letter is inaccurate.

In addition to a zoning letter, the Lender can also request a zoning endorsement to their title policy as an extra layer of protection against zoning issues. A zoning or ALTA 3 endorsement acts as an extension to the Lender’s title insurance policy. The endorsement will insure the Lender against loss sustained if the insured use of the mortgaged property is deemed invalid by a court order. This provides a path for the Lender to recoup some of its losses directly through the title insurance policy.

Title underwriters typically require a zoning letter to issue an ALTA 3 zoning endorsement. After review of the letter, the title company may provide additional requirements needed to issue the endorsement such as an ALTA survey or a zoning report from a third-party consultant. Since requirements vary by title insurer and jurisdiction, the Lender should consult the title company handling its loan policy.

Lenders should consider the costs incurred by the Borrower associated with obtaining the endorsement (around $0.50 or $1.00 per $1,000 of insurance) when choosing to add this coverage. However, if the zoning status of property is unclear costs of the zoning endorsement may provide the Lender with the necessary assurances to move forward with a transaction.

By ensuring that the property is appropriately zoned for the Borrower’s proposed use, Lenders can protect both their financial interests and the integrity of the SBA loan program. Taking these steps prior to loan closing will help reduce the likelihood of costly zoning issues arising later, ultimately providing greater security and peace of mind for both Lenders and Borrowers.

For further assistance with SBA due diligence and loan closings, please contact the attorneys at Starfield & Smith, P.C. at 215-542-7070 or email us at info@starfieldsmith.com.