We all know that the flood insurance rules apply when a loan is secured by a primary residence or a warehouse in which a business operates. These situations are very straightforward and would seem logical to be subject to flood insurance rules. The challenge with flood insurance, however, relates to less common situations that wouldn’t seem logical for the rules to apply. For example, many commercial lenders don’t think that flood insurance rules should apply when a structure is not given any value on an appraisal, even though it is technically part of the loan collateral.
Why Properties With No Value Need Flood Insurance
The idea behind thinking that flood insurance rules shouldn’t apply for structures that don’t have any appraised value is that a financial institution doesn’t really care about these old and often unused structures, when the value of the land far exceeds the amount of the loan. While this is a completely understandable approach for collateral purposes (from a safety and soundness perspective), the challenge with this line of thinking is that flood insurance rules absolutely apply - even if a bank or credit union doesn’t care at all about the value of any structures because the land value is sufficient to cover the collateral from a loss/risk perspective.
This situation often comes up in agricultural lending when the main purpose of the loan is to purchase many acres of farmland (e.g. 200 acres), yet the collateral includes a few structures such as an old barn, silo, or even an old dwelling. From a collateral perspective, an old barn, silo or even dwelling aren’t usually going to make any impact at all on the fairly high value of the farmland. Therefore, lenders often don’t care whether or not the value of such structures is considered in an appraisal of the collateral.
Flood Insurance Compliance For Buildings With Limited Value
I have personally seen instances where ag lenders specifically ask an appraiser to not consider structures in the appraisal as they don't need them for the value of the farmland. While this is acceptable from a collateral perspective, this approach makes it extremely difficult to ensure compliance with flood insurance rules. From a compliance perspective (whch is, of course, the point of this article), the problem is that there is usually evidence hidden somewhere in the file that references such structures. This evidence is often found in the form of either a brief statement by the appraiser about the request not to review the structures, or a statement from the lender on the appraisal request letter asking the appraisal to not include the structures in the evaluation.
For example, I have seen appraisal summaries that include statements like the following:
"The subject property contains an approximate 11 acre site located in the southeastern corner of the property. This site is abandoned and what is assumed was a dwelling has been torn down with only the foundation remaining. Improvements still present include a cattle barn, wood shed, 4 steel grain bins, and wooden granary. All of the improvements are old and in a state of disrepair or lack functionality. No value is given for the improvements; however, the underlying land could be utilized for crop production if the improvements were removed and the site acres were put into crop production."
When I review "land only" loans for flood insurance compliance, I always look for these hidden statements and have even been known to pull up Google Maps to double check for such structures. From experience, I have found that many agricultural and commercial “land only” loans actually contain structures that are subject to flood insurance requirements, even though the commercial appraisal doesn’t give them value or even really mention or acknowledge them.
Flood Insurance Rules for Buildings with No Value
The bottom line is this: Flood insurance rules apply to all structures/buildings taken as collateral regardless of the "value" placed on such structures by the bank or appraiser. Financial industry regulators have made this clear as they specifically addressed this topic in their joint frequently asked questions which they originally published in 2009.
From the interagency FAQs:
24. Some borrowers have buildings with limited utility or value and, in many cases, the borrower would not replace them if lost in a flood. Is a lender required to mandate flood insurance for such buildings?
Answer: Yes. Under the Regulation, lenders must require flood insurance on real estate improvements when those improvements are part of the property securing the loan and are located in an SFHA and in a participating community. The lender may consider ‘‘carving out’’ buildings from the security it takes on the loan. However, the lender should fully analyze the risks of this option. In particular, a lender should consider whether it would be able to market the property securing its loan in the event of foreclosure. Additionally, the lender should consider any local zoning issues or other issues that would affect its collateral.
As you can see in this guidance, structures that don’t have any collateral significance are still subject to the flood insurance rules. This means that financial institutions are required to ensure that all flood rules are followed, including pulling a flood determination and requiring insurance, when appropriate.
Carving Out Collateral to Avoid Flood Insurance
It is also important to point out that FAQ 24 provides an option for lenders who don’t want to deal with flood insurance on structures which don’t provide any collateral value: to carve out the buildings from the security for the loan. In short, this guidance states that it is possible to exclude the buildings from the collateral so that the flood insurance rules don’t apply.
It should be noted, however, that lenders will want to use caution in doing this as they need to be able to realize their collateral in the event of a default. For example, it would not be appropriate to “carve out” a barn that is located inside the middle of 100 acres of farmland that also does not have a direct road access.
On the other hand, a silo on the far end of 50 acres may be able to be removed from the collateral if it could be easily accessed from a separate road. Also, it is important to note that carving out collateral is a question for an attorney and beyond the scope of flood insurance rules and regulatory compliance.
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