How to Reduce Legal Risk in a Recessionary Economy for Developers and Lenders

According to statistics, there are statistically more construction-related litigation cases than any other loan litigation claims in any given year, and these numbers are even more during a recession.

It’s safe to claim we can respond to the question, “Does history repeat itself? after experiencing a number of recessions and identifying important trends. The answer is a loud “yes,” but we can use what we have learned from the past to lessen the risk by planning ahead more effectively.

The news stories of today make it clear that a recession is either coming or has already begun. In any case, the commercial real estate industry has historically been affected by market downturns, and this situation is no exception.
Although past recessions have had both beneficial and negative effects on companies, from credit restrictions to changes in sales volume, the legal issues that arise are probably the most expensive and long-lasting. Understanding the risks that arose during previous recessions and how they were handled may help lenders and developers stay safe during these trying times.Additionally, being aware of the past might help both parties take the appropriate safety measures to prevent a repeat of the same events.

A Review of Previous Recessions

According to statistics, there are statistically more construction-related litigation cases than any other loan litigation claims in any given year, and these numbers are even higher during a recession. Recessions have caused and are expected to continue to cause a variety of legal problems with building financing. Without market changes, these loans are already risky, but during a recession, cash-strapped contractors or those who underbid a project may end up doing shoddy repairs. As a result, there may be more faults as a result of hurried work, supply chain delays, labor shortages, cost-cutting measures, and/or manufacturing issues.

Construction-related issues can become more common and more expensive to handle during a recession, in addition to a rise in construction-related issues. Government shutdowns can affect the timing of permits and even necessitate the suspension of project work amid a recession and pandemic, in addition to the more usual weather delays, workmanship concerns, and supply chain delays. Events of default under the terms of the loan, fines, or extension costs may be triggered by delays. They may also have an effect on long-term funding sources and result in higher carrying costs. Delays may also result in guarantor responsibility for some loans, making it harder for the project to sustain in the long run.

Of course, variable interest rates are sometimes a sign of a volatile market. Early interest rate locking, however, can have benefits and drawbacks. Variations in interest rates can have a significant impact on the expenses of completion for those uncommon construction-to-permanent loans. Numerous lenders had to make difficult decisions regarding the feasibility of loan commitments during previous recessions in the face of claims from borrowers, which led to many borrowers with forward commitments having loan approvals revoked as a result of shifting interest rates.

Broken promises may lead to protracted legal proceedings and, in rare cases, punitive damages. Additionally, the impact and delays that follow might virtually ruin a project’s feasibility. There may also be personal liability if there are guarantors on the loan and the borrower defaults. Numerous lawsuits involving loan commitment termination were filed during previous recessions, and many courts carefully considered whether the reasons for the termination were valid.

Finally, a less reliable renter pool can result from recessions. Borrowers are more likely to default on their mortgage payments when tenants are unable to uphold their rental responsibilities. It should come as no surprise that during a recession, there are more foreclosures, deeds in lieu of foreclosure, and collection attempts. Due to the financial uncertainty, there are more bankruptcies.

Risk Reduction in a Recessionary Economy

Contrary to what many commercial lenders and developers may believe, a recession can really present opportunities. With appropriate planning, some risks may even be reduced. I genuinely believe it comes down to these ten suggestions after decades of risk management and litigation in the aftermath and with the benefit of hindsight:

To completely comprehend all of your contract provisions, have a new set of eyes look over your loan documentation, building contracts, and land purchase agreements. Make sure to carefully review your notice requirements and force majeure clauses and to adhere to them. Throughout the course of the project, review your documentation frequently, especially if construction loans are involved.
Ensure that your deadlines are consistent across all of your documents. Give yourself plenty of time to account for conceivable delays that might be unavoidable.
Make sure you start off by keeping precise, thorough records and notes. Follow up on the performance of the contract, noting any deviations or delays.
Inspect the area on a regular basis. Lenders should personally verify that deadlines are being followed while owners and developers should be monitoring their contractors and the project’s progress.

The key is communication. Although it sounds cliche, effective communication can save a relationship and raise the likelihood that a loan or contract can be modified when necessary.
Examine and keep your insurance.
Limit your promises. Although managing expectations may seem easy, it can sometimes make a difference in a project’s success.
Maintain your lane. In a recent ruling, a judge stated that “[i]f a lender exercises excessive control over a borrower, Although there is no fiduciary responsibility, “if a lender takes a particularly active role in the business decisions of the borrower,” it “may become liable for tortious interference,” even in the absence of one., a lender can take on the role of fiduciary rather than creditor.

Make use of specialists who have the expertise and knowledge to handle any issue that may arise, such as construction managers, inspectors, supervising architects, lawyers, and/or accountants.
Request document revisions as needed, secure the relevant approvals, and record any alterations to agreements.
Following these ten procedures will reduce legal risk, if not completely eliminate it, even during a recession.

We are ready to assist investors with Santa Ana Commercial Real Estate properties. For questions about Commercial Real Estate Investments, contact your Orange County commercial real estate advisors at SVN Vanguard. 

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