Best Practice: Restrictive Covenants and Deed Restrictions: A Hidden Risk to SBA Lending

When SBA lenders evaluate title risk, the focus is often on liens, ownership, and access. However, restrictive covenants and deed restrictions — often buried deep in recorded documents — can pose a significant and sometimes overlooked threat to SBA loan eligibility. These restrictions must be evaluated carefully to ensure they do not impair the collateral or the borrower’s ability to operate the business from the property since failure to do so can expose the lender to a partial or full denial of the SBA guaranty.

Restrictive covenants and deed restrictions are recorded limitations that govern how real property may be used, developed, or conveyed. These covenants and restrictions “run with the land,” meaning they bind not only the current owner but all future owners as well. They are commonly imposed by developers, owners’ associations, and/or prior owners and may limit or prohibit specific uses or activities. Common examples include: (1) use restrictions, such as “office use only,” “no industrial manufacturing,” or “no food service”; and (2) prohibitions on certain industries or activities, such as adult entertainment or cannabis-related businesses.  While not exhaustive, these examples illustrate how such restrictions — though not affecting title ownership — can materially impact the property’s value, marketability, and usability, all of which are relevant under SBA collateral and eligibility requirements.

As the name implies, deed restrictions are located within a deed in the chain of title to the property, while restrictive covenants can appear in a number of other documents, but both kinds should appear in the title exceptions listed in a title commitment. These documents must be carefully reviewed and analyzed to confirm that no covenants or restrictions conflict with the borrower’s business operations.

It is important to note that title insurance does not insure over a borrower’s inability to use the property for a specific purpose. As such, a recorded covenant or restriction could create an SBA loan eligibility issue if it prohibits or limits a borrower’s intended business use. For example, if an SBA loan finances the acquisition of real estate for a restaurant start-up and subsequent to the loan closing, a restrictive covenant is discovered that prohibits food service or limits the property to “only office use” could effectively preclude the borrower from operating the business at that location and create a loan eligibility issue. In such a case, the SBA may determine that the lender failed to verify the ability of the borrower to conduct its business at the property, rendering the loan ineligible or improperly underwritten.  Such a determination could result in a repair or denial of the SBA guaranty.

To mitigate this risk, early identification and detection is key. Lenders should obtain and thoroughly review the vesting deed (i.e. the deed(s) vesting ownership of the property into the current owner(s)) and all title exceptions, compare the borrower’s NAICS code and actual operations against the precise covenant language, and consult legal counsel when the intent of the language is unclear. By integrating careful title review by experienced legal professionals into the closing process, lenders can reduce or eliminate exposure of the SBA guaranty to repair or denial while continuing to close loans efficiently and compliantly. For further assistance, please contact the attorneys at Starfield & Smith, P.C. at 215-542-7070 or email us at info@starfieldsmith.com.