Flood Insurance and Building to be Demolished

Issue/Inquiry

The Bank has received a commercial mortgage loan application for a property for which there is presently a commercial structure on the land. This structure will be torn down and a new structure will be built. The Bank is considering the vacant land as the collateral for the loan, but the time period when the present structure will be torn down and the new structure constructed is uncertain. While the current structure is commercial, the new structure may not be.

Is flood insurance required?

Response Summary

The Flood Rules do not distinguish between buildings that will be demolished and those left standing. If the building is covered by the mortgage, it secures the loan and must be covered by flood insurance. Alternatively, the Bank could “carve” the building out of the mortgage, which is allowed for non-residential properties. In such case, the loan would be secured only by the land, and flood insurance would not be required. With respect to new construction, proof of flood insurance coverage would be required when 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.

Response Detail

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 Bank is considering only the land as collateral, but there is a commercial structure on the land that will be torn down. The Flood Rules provide no exception for a building that will be demolished. As long as the building is covered by the mortgage, it secures the loan. This means that the Bank must 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.

The Bank could alternatively “carve” the commercial building out of the mortgage securing the loan. This is allowed for non-residential properties. If the building is not collateral, flood insurance would not be required. The loan would, in effect, be secured by the land until the construction of the new structure 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 Questions and Answers Regarding Flood Insurance (“Interagency Q&A), Q – 24.

Regarding the construction phase, it is a prudent practice to have insurance coverage for buildings that will be located in a special flood hazard area. Flood insurance is not required, however, until a specified drawdown of the loan for actual construction is made. Thus, the Bank 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.

Nevertheless, the Bank must require the borrower to have flood insurance in place before it 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) on the property securing the loan. If the Bank elects to use this approach and does not require flood insurance to be obtained at loan origination, then it must 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.

The Bank indicates that the building to be constructed may be residential in nature. This will affect the coverage limits and the nature of the property and related personal property covered; it will not affect whether and when flood insurance coverage must be obtained.

This entry was posted on Monday, May 21st, 2018 at 6:00 am.