Every mortgage loan agreement contains provisions that address casualty and condemnation (i.e., eminent domain) affecting the property. All such provisions give the lender some degree of control over the proceeds and identifies what happens to the proceeds, and are usually given scant attention. However, these provisions often can be negotiated, at least with respect to how the proceeds are handled for any restoration of the property.
As a borrower, a property owner doesn’t want to be hamstring with red tape if the proceeds are not material, and a lender shouldn’t want that either. However, a lender needs to protect its security interest in the property. The trick is to determine where to draw the line.
Typically, the loan agreement includes casualty and condemnation provisions that simply provide all proceeds from such events go to the lender, which may be applied to paying down principal on the loan.
Consider the following scenario, a new storm sewer is scheduled for construction along the road where mortgaged property is located. Eminent domain is being utilized to take a tiny sliver of the properties adjacent to the road. The amount of property to be taken has no material impact on the value of the mortgaged property and accounts for maybe 1-2% of the property. However, if the loan agreement’s condemnation provision does not include a materiality threshold then the borrower will need to notify the lender, pay a few thousand in fees to the lender to cover its legal fees and contend with red tape over the use of the proceeds.
Typical approaches to identifying what condemnation or casualty events are material include a dollar threshold and a percentage of the property that is affected. When such an event does not trigger these thresholds then the borrower will retain all or some level of control over how the insurance or condemnation proceeds are spent.
For example, a restoration threshold will typically be set at around 5% of the outstanding principal balance on the mortgage loan. Therefore, if the proceeds the result from the casualty or condemnation event do not exceed that threshold then the lender is more likely to permit borrower to keep the proceeds.
Additionally, a lender will want to look at how the property is functionally affected by such events. For example, if the land taken by eminent domain is less than 10%, the percentage of leases that remain in full force and effect after a casualty event exceeds 75% or the less than 35% of the improvements were destroyed, then the lender will be more likely to permit the borrower to restore the property and, depending on other criteria, receive the proceeds for restoration.
When negotiating loan agreements, borrowers should give some attention to the casualty and condemnation (eminent domain) provisions, with the goal of obtaining as much flexibility as possible.