Flood Insurance for Demolition of Building and Construction of New Building

Issue/Inquiry

A borrower has purchased a property with cash that currently has a warehouse/office facility on it and is located in a flood zone. The warehouse is to be demolished and a multi-family building will be constructed in its place.

The Bank is providing a bridge loan to cover the cost of demolition of the warehouse and to finance the site work preparation only.  A third party will be financing the construction of the multi-family building. The collateral for the loan from the Bank will be a first mortgage lien and assignment of all leases/approvals/permits on the property.

The Bank asks what value should be used for the building being demolished and at what point should that insurance coverage be based on the new construction value.  

Response Summary

The Bank must require the borrower to obtain flood insurance for the commercial building prior to closing and maintain such insurance coverage until the building is torn down. In the alternative, it may “carve” the building out of the mortgage, so that it does not need to be insured.

For buildings under construction, flood insurance does not have to be in the full amount of the finished project from the beginning, but can be purchased to keep pace with new construction. What the Bank must determine at each stage of construction will be the replacement cost of the structure already completed.  The cost of materials will not be included, since these are not insurable against flood hazard. If sufficient insurance is obtained to cover the value of the structure at each phase of construction, such will satisfy the flood insurance requirements.

Response Detail

Flood Insurance for a Building that will be Demolished

Under the Flood Rules, a lender shall not make, increase, extend, or renew any loan secured by improved real property unless the building securing the loan is covered by flood insurance. The amount of insurance must be at least equal to the lesser of the outstanding principal balance of the designated loan or the maximum limit of coverage available for the particular type of property under the National Flood Insurance Act. 12 CFR §339.3.

In this case, the intention of the borrower is to tear down the commercial structure soon after closing. When real estate improvements are part of the collateral securing a loan, however, they must be insured against flood damage. The limited value or utility of the buildings is not relevant as to whether they must be insured. The Bank must, therefore, require the borrower to provide proof of flood insurance covering the building prior to closing and to maintain it until the building is torn down.

There are only two exceptions from the mandatory flood insurance requirements:

• If the property is state-owned and covered under a policy of self-insurance satisfactory to the director of FEMA.
• If the original principal balance of the loan is $5,000 or less, and the original repayment term is one year or less. 12 CFR §339.4.

In calculating the amount of insurance to require, the Bank and the borrower (either by themselves or in consultation with the flood insurance provider or other appropriate professional) may choose from a variety of approaches or methods to establish the insurable value. They may use an appraisal based on a cost-value (not market-value) approach, a construction-cost calculation, the insurable value used in a hazard insurance policy (recognizing that the insurable value for flood insurance purposes may differ from the coverage provided by the hazard insurance and that adjustments may be necessary; for example, most hazard policies do not cover foundations), or any other reasonable approach, so long as it can be supported. The Bank should try to avoid insuring the property for more than the NFIP would cover. Interagency Questions and Answers Regarding Flood Insurance (“Interagency Q&A”), Q. 9.

The Bank, however, has an alternative to requiring insurance for the building, and that is to “carve” it out of the mortgage securing the loan. If the building is not collateral, flood insurance would not be required. The loan would, in effect, be secured by vacant land until the construction began. The Bank should consult with its outside counsel as to the desirability of following this course of action and how it would be accomplished. Interagency Q&A, Q.24.

Flood Insurance and a Building under Construction

While the Bank is not funding the construction of the multi-family residential building, it still has a continuing obligation to maintain adequate insurance on the property, since its mortgage will cover the property and the improvements on it. The force placement rules, for example, require the Bank to notify the borrower at any time during the term of the loan if it determines that the flood insurance covering the property is not in a sufficient amount. 12 CFR §339.7. This means that the flood insurance must steadily increase as the value of the improvements under construction increase.

Under the Flood Rules, a lender may allow a borrower to defer the purchase of flood insurance until either a foundation slab has been poured and/or an elevation certificate has been issued; or, if the building to be constructed will have its lowest floor below the Base Flood Elevation, when the building is walled and roofed.

The lender, however, must require the borrower to have flood insurance in place before the lender disburses funds to pay for building construction (except as necessary to pour the slab or perform preliminary site work, such as laying utilities, clearing brush, or the purchase and/or delivery of building materials). It must also have adequate internal controls in place at origination to ensure that the borrower obtains flood insurance no later than when the foundation slab has been poured and/or an elevation certificate has been issued. Interagency Q&A, Q.22.

After the foundation is in place, flood insurance does not have to be in the full amount of the finished project, since an NFIP policy will pay no more than the insurable value, but can be purchased to keep pace with new construction. FDIC Compliance Examination Manual, V – 6.2; Interagency Q&A, Q.14. This means that the amount of flood insurance coverage will be incrementally increased from time to time to cover the increasing value of the structure as it is constructed.

In making the determination, however, two particular factors should be kept in mind:

• The materials or supplies used in construction or repair are not insurable against flood hazard unless they are in an enclosed building located on or adjacent to the premises. Federal Reserve Bank of Philadelphia, Consumer Compliance Outlook, Fourth Quarter, 2011. These materials should be covered under a Builder’s Risk insurance policy, but unless they are in an enclosed building, their value would not be considered for flood insurance purposes at any particular phase of construction.
• The amount of available flood insurance would not be affected by whether a survey and/or elevation certificate has been obtained, as the NFIP allows a policy to be issued based on estimated elevation from the builder’s plans. Upon renewal, the policy will be issued based on actual elevation and value. FEMA, NFIP Flood Insurance Manual (GR 4, APP 6, and PRP 16).

What the Bank will determine at each stage of construction, then, will be the replacement cost of the structure already completed. The Bank should document the basis for its determination of this value. If insurance is obtained sufficient to cover this amount, it will satisfy flood insurance requirements, even if the better part of any disbursement is for the purchase of materials, which cannot be covered by flood insurance. As the value of the structure increases, the amount of flood insurance coverage will be increased to keep pace with it.

This entry was posted on Monday, May 9th, 2016 at 3:00 pm.