What Borrowers Need to Know About Apartment Lender Inspections
Lender inspections can raise the blood pressure of any borrower, but if you know what to expect, there’s little cause for concern. In most cases, lender inspections occur for one of two reasons; inspections that occur as part of a lender’s due diligence before closing on a traditional multifamily loan, and construction loan progress inspections that occur during the construction or substantial rehabilitation of a project.
In most cases, construction loan proceeds are disbursed over time, and a lender may require a property inspection before each disbursement, or “draw,” in order to ensure that the project is proceeding on time and without any issues.
Typically, a lender will not conduct the inspection themselves; instead, they will hire a third-party inspection firm to conduct the inspection and report back with the results. Despite this, some larger lenders do have internal teams that may conduct the inspection themselves. Inspections could involve a single inspector, or, for larger projects, an engineer and/or architect that will conduct a more in-depth inspection of the property and site.
What to Expect From an Apartment Construction Lender Inspections
In most cases, a lender will hire a third-party inspection company to conduct the inspection for them. For construction loans, one of the most important factors is overall project completeness. For example, if 25% of construction loan proceeds have been disbursed, but the project is only 10% complete, this could be a serious issue.
Specific aspects of a building (whether complete or under construction) that may be assessed by a lender inspection often include:
Building foundations
Materials quality
Materials storage
Site security
Site cleanliness
Site safety and legal precautions
HVAC systems
Amenities
Roofing
In addition, inspectors may also look at “soft aspects” of the project and may take other actions, including:
Project accounting review, including cost statements, invoice tracking, and funding analysis
Relaying builder questions or needs to lenders/owners
Examining and verifying licenses, permits, zoning, insurance, taxing, and bonding for the construction company and/or general contractor
Conducting general site photography, particularly noting any areas of concern
Preparing for a Lender Inspection: What You Need to Know
If you’re a developer or investor and know that a lender inspection is upcoming, there are several steps you may wish to take in order to prepare your property. First, make sure that maintenance has been conducted recently. This is specifically important for construction projects, where there are many moving parts and the developer needs the next draw to move forward with the project. A dirty or scattered construction site will certainly create a red flag for the lender, which could lead to difficulty or delays in getting the next disbursement, even if the project is otherwise on track.
After making sure maintenance is up to par, you will want to make sure to meet with your architect and general contractor to ensure that the project’s progress is meeting the agreed-upon deadlines. If you are concerned they may not be being straightforward with you, it may be advisable to hire a third-party inspector to check out the property themselves. For non-construction lender inspections, it may also be worthwhile to hire a third-party inspector to do a quick review of the property.
Apartment Lender Inspections vs. Project Condition Assessments (PCAs)
Apartment lender inspections are sometimes compared to PCAs, or project condition assessments (sometimes called property condition assessments), which are relatively similar in nature. A PCA report is usually commissioned for property acquisition or refinancing, rather than a construction project.
Like a lender inspection, engineers, architects, and inspectors will typically examine a property. However, the aim is generally to determine the need for immediate repairs, and to calculate the appropriate amount required for replacement reserves, money that must be set aside by the borrower (often in escrow) to cover regular or unexpected building repairs. Replacement reserves are typically denominated in dollars per unit per year. For instance, a 20-unit apartment building with $250 in replacement reserves per unit would need to set aside $5,000/year in replacement reserves.
In addition to lender-ordered PCAs, a PCA may also be commissioned by an investor to ensure the building they wish to purchase is in good condition.
For CMBS loans, PCAs on buildings that serve as collateral for commercial mortgage-backed securities may also play a role in the rating for that individual security.
Apartment Lender Inspections for HUD Multifamily Loans
For Fannie Mae, Freddie Mac, or HUD multifamily loans, the inspection requirements may be somewhat stricter.
For example, the popular HUD 221(d)(4) construction or substantial rehabilitation loan requires an extremely in-depth series of construction inspections to ensure that a project is on-time and on budget. Projects funded by HUD 221(d)(4) loans will require separate engineering and architectural reports, which often need to be updated throughout the process.
For substantial rehabilitation projects, a capital needs assessment (CNA) will also need to be ordered to determine the repair needs and project condition. In addition to these reports, a variety of other pre-construction reports, such as market analysis, an appraisal by a HUD multifamily approved appraiser, a seismic report (in some states), and a Phase 1 Environmental Assessment (ESA) will also be generally required.
While it’s true that many of these will be required for non-HUD-multifamily approved construction projects, the depth and detail requirements of these inspections and reports are generally larger in scope, which often leads to the long closing times (often 6-12 months) for HUD/FHA multifamily financing in comparison to other types of construction and rehabilitation loans.
Apartment Lender Inspections vs. Environmental Assessments (ESAs) and Other Third-Party Reports
It should be noted that apartment lender inspections are not the only form of inspection that a borrower needs to suffer through before getting approved for a loan, particularly a construction loan. As mentioned in the above section regarding HUD multifamily loans, a borrower may need to get a variety of other third-party reports, including a Phase I Environmental Assessment (ESA).
Phase I Environmental Inspections are conducted to ensure that a building and the surrounding land are safe and free from any contamination, or if the property itself has negatively impacted the environment.
A Phase I ESA generally includes the following:
In-person, physical review of the site and nearby properties.
Review of historical records, including fire insurance maps and historical topographic maps.
Review of local and state records from environmental, health, building, and fire departments.
Interviews with occupants, operators, property owners, occupants, and (potentially) neighbors or previous contractors.
Review of databases regarding storage tanks and any use, storage, or disposal of hazardous substances.
Investigation of any environmental liens or other issues.
A review and investigation of any known use of asbestos-containing materials or lead paint that could remain harmful to occupants.
As with most inspections and other third-party reports, Fannie Mae, Freddie Mac, and HUD have additional requirements for the ESA to comply with their specific requirements.
Apartment Lender Inspections vs. Section 8 Inspections
If an investor is attempting to purchase or refinance a building currently utilizing the HUD Section 8 program, they may also be subject to an additional Section 8 inspection, either before, during, or after the closing of the loan. These inspections can also come randomly or as the result of compliance or general audits, which could also occur during the loan closing process. Section 8 inspections are not ordered by conventional lenders but may be required if an investor is utilizing HUD multifamily financing for a property already using the HUD Section 8 program.
Inspections may be conducted by either an outside firm or by an inspector from the local public housing authority (PHA). Like other types of inspections, owners should be careful to ensure that their building is in good condition and does not pose any major hazards to residents prior to the inspection.
In general, inspectors will look at each unit and the overall building and conduct checks including:
Site foundation review
Smoke detector check
Stair, rail, and porch condition
Fire exit check
Interior stair review
HVAC and water heater check
Plumbing, sewer, and water supply check
Elevator safety and maintenance review
Lead-based paint check
Electricity and electricity hazards examination
Potential security issues review
Air quality and ventilation check
Kitchen review to ensure the kitchen has a working refrigerator, stove, oven, and sink
Ensuring there is an adequate amount of room for food storage and preservation (counter and pantry)
Bathroom check to ensure toilet flush, sink, and tub/shower operation
Examination of the window, ceiling, floor, and wall conditions
Review of potential pest infestations, garbage, and debris check
Specific issues to look out for include:
Asbestos or lead paint issues
Lack of handrails on the exterior or interior stairs
Lack of window locks or screens
No weathertight windows or doors
Lack of bathroom fan/ventilation
Tub caulking problems
Lack of locks or deadbolts on exterior doors
Broken carbon monoxide and/or smoke detectors
Paint flaking (especially if there are children in the unit)
Improper pressure release valves on hot water heaters and boilers
Lack of smoke detectors on every level
Failing a Section 8 inspection can be relatively serious, and depending on the severity of the failure, could lead to the building owner being banned from receiving Section 8 rental subsidy payments. If the closing of a loan is contingent on rental income derived from the Section 8 program, and the building has failed an inspection, the loan is unlikely to close, or at least will not close until the building has passed (typically with flying colors).
What Happens If You Fail a Lender Inspection?
Failing a lender inspection is never a good thing, but it may not be the end of the world. The consequences of inspection failure will vary greatly depending on the specific project, lender, and the progress of the project itself. In the best-case scenario, the inspector and/or lender may provide a list of recommendations that could bring the project back into compliance. If these issues can be fixed quickly, a new inspection can be conducted within a few days or weeks, giving the developer or owner a new chance to pass.
If a construction project is seriously off-track, however, or if a non-construction acquisition inspection has revealed a serious issue with the property, there could be more serious consequences. For construction projects, a lender could require that the developer injects more cash into the project to remedy an issue. They could also increase the interest rate of the project, add additional fees, or foreclose on the property (if the issue is serious enough). In general, failure of an inspection will cause project delays, which will add more labor and insurance costs to the project.
For non-construction acquisition financing inspections, a lender could simply decide to not approve the loan. They could also agree to approve the loan for a smaller amount, sometimes contingent on a reduction of the sale price for the property. The lender could also require that the current owner fixes the problem before approving financing for the buyer. Similar consequences could occur if a current owner is seeking to refinance for a project they currently own.