By Joseph A. Ernst, Esq.
Under SOP 50 10 5(D), one of the permissible uses of loan proceeds is for the construction of new buildings and renovations to existing buildings. SOP 50 10 5(D), page 81. Furthermore, it is clear under the SOP 50 10 5(D) that twenty percent (20%) of a newly constructed building may be leased “permanently” to a third party tenant. SOP 50 10 5(D), page 137. However, effective as of October 1, 2011, the SOP 50 10 5(D) now contains an express prohibition against using loan proceeds to improve or renovate any part of the space that is leased to a third party tenant. In the context of an existing building, it typically is relatively easy to identify and segregate the costs of making improvements or renovations to space leased to a third party tenant and, hence, relatively easy to comply with the prohibition on using loan proceeds to improve or renovate the space leased to a third party tenant. In contrast, in the context of ground up construction, the distinction between using loan proceeds for the permissible use of new construction and using loan proceeds for the impermissible use of improving space leased to a third party tenant can be much more difficult to make, particularly if the Lender does not have a through understanding of what is being constructed and why.
In general, loan proceeds used to construct the building’s shell and the mechanical, electrical and other utility systems serving the entire newly constructed building are permissible under the SOP 50 10 5(D), even if part of the newly constructed building will be leased to a third party tenant. In contrast, loan proceeds used for improvements to a third party tenant’s space that are designed or intended for the third party tenant’s specific or unique use of its space are prohibited under the SOP 50 10 5(D). In general, if the improvements are requested or needed by the third party tenant to operate its particular business operations in its space, then loan proceeds cannot be used for such improvements. By way of an example, its is permissible under the SOP 50 10 5(D) to use loan proceeds to construct all of the structural floors for ground up construction. However, under the SOP 50 10 5(D), it would be impermissible to use loan proceeds to finance the tenant’s fit-out or even to reinforce the structural floor of the third party tenant’s space if the third party tenant’s use of its space dictated that its floor have a higher than normal load bearing capacity. Lenders should be mindful of who will directly benefit from the improvements and wgho requires the improvements when conducting this analysis.
Because there is a grey area in ground up construction between the permissible use of loan proceeds for new construction and the impermissible use of loan proceeds for third party tenant improvements, Lender’s need to be cognizant of this distinction between permissible and impermissible use of construction loan proceeds for certain types of improvements. In ground up construction, particularly in the case where a third party tenant is already lined up to lease part of the space, a careful and through review of the construction contract is warranted to ensure that loan proceeds will not be used for impermissible improvements to a third party tenant’s space. If the construction contract is unclear as to the scope of work and/or the improvements that are to be made to the third party tenant’s space, then the Lender must obtain clarification to ensure that the loan proceeds will be used for a permitted use. In addition, in many instances, the borrower/landlord would not be undertaking ground up construction without having first secured in some fashion the rental income from a third party tenant; consequently, there may be a letter of intent or lease with the third party tenant. If this is the case, the Lender should carefully scrutinize any such letter of intent or lease with the third party tenant to ascertain if improvements are being undertaken that are unique or specific to that particular third party tenant. Should this be the case, care must be taking when disbursing the construction loan proceeds to ensure that such tenant specific improvements are not funded with the loan proceeds.
For more information regarding the prohibition on using loan proceeds for third party tenant improvements , please contact Joe at JErnst@StarfieldSmith.com or (215) 542-7070.