Zoning Due Diligence 101

By Rusty A. Fleming and Frances H. Kim

In commercial real estate transactions, zoning diligence for existing developments can often be overlooked or treated as an easy “check the box” item on the closing checklist. However, conducting proper due diligence on zoning matters should be viewed in the same light and with the same importance as title and survey matters. There are various zoning issues that may currently impact a commercial property or could impact the property in the event of a future casualty or condemnation. In fact, similar to obtaining title insurance, the owner and/or its lender may need to obtain insurance for zoning matters. In this article, we will discuss the scope of zoning diligence, the types of zoning conformance and tools available to owners and their lenders to address zoning matters.

Zoning Letters vs. Zoning Reports

For all real estate deals, ordering a zoning report is highly recommended. However, on some occasions, a borrower may only want to provide a lender with a zoning letter, or, in the case of a real estate purchase, the seller may want to limit the due diligence to a zoning letter. Zoning letters, which are handled by the local municipality where the property is located, will often consist of two components:

1. They will provide the current zoning classification of the property: industrial, retail, planned unit development, residential, special zone, and so on. The current classification is not always helpful, however, because the property could have been built prior to the current zoning ordinance being passed.

2. They will usually say that there are no open violations. This does not mean that there are no non-conformance issues; it merely means the applicable zoning governance entity is not aware of any violations.

Ultimately, the zoning letter will provide some basic information, but zoning codes change from time to time, and real estate usually has a useful life that outlives the frequent changes to zoning codes. Therefore, one should order a zoning report and can choose from several companies to do so.

The Planning & Zoning Resource Company is one of the most well-known zoning consultants. From a branding standpoint, its name dominates the market to the point where some refer to zoning reports as “PZRs.” Other brands, like Zoning Info, also provide zoning reports. Each will provide a report consisting of a five- to- ten page summary addressing use, setbacks, heights, parking, side yards, and other characteristics that are covered by the zoning code. The report will also include a summary categorizing the property as one of three things: (1) non-conforming, (2) legal non-conforming, or (3) conforming.

Conforming, Non-conforming and Legal Non-conforming Classifications

a. Conforming Properties

If a property is designated as “conforming,” that means the building is built perfectly within the current zoning codes applicable to the property. This means that there are no violations of uses, setback lines, landscape buffers, height restrictions, parking requirements, or other zoning requirements. If a zoning report comes back with a conforming designation, there is nothing further to be done, and the deal can move forward toward closing.

b. Non-Conforming Properties

The second type of zoning designation is “non-conforming.” A nonconforming property does not comply with the current zoning code and is not grandfathered in, meaning that the property was built prior to the existence and enforcement of the current zoning code and that there is no special permit for the property or statutory exception. There is usually no “quick fix” for a non-conforming property. For example, the owner could apply for a variance, but there is no certainty that an exception would be granted. The owner may have to engage in extensive renovation, such as tearing down a portion of the building or adding additional parking to comply with the code.

Although non-conformance is a major issue, it is also a rare one. Builders, developers and their lenders are cognizant of non-conformance issues and ensure that newly constructed properties comply with the local zoning code.

c. Legal Non-Conforming Properties

In between “conforming” and “non-conforming” is “legal non-conforming.” Legal non-conforming means that the property was constructed prior to the current zoning code, and while the property may violate the current code, it is grandfathered in. As such, the property is not in any violation of the code; it is non-conforming, but legally so.

What kinds of non-conformances designate a property as legal nonconforming? It could be something minor; for instance, the property may be missing two parking spaces, which could be fixed by restriping the lot. Another common legal non-conforming zoning issue is found in cities which are trending towards having more green space. Consequently, these cities require setbacks to be positioned farther back and enforce more restrictive side yard and green space requirements. A property may have a specific use, such as an office or a gas station, that was built in an area that has since implemented more permitted uses. Even so, as long as the property is grandfathered in, there is not much cause for concern.

However, the significant area of concern with respect to legal-nonconforming properties lies in issues such as condemnation or casualty. In the instance of casualty, since the zoning code under which the property was built no longer exists and the property does not comply with current zoning codes, the owner’s sole option may be to look to a rebuildability clause in the local zoning code. These clauses state that if a building is legal non-conforming, the property may be rebuilt in accordance with the original structure and continue to be grandfathered in, but only under certain parameters. Such parameters may include a timing threshold, which provides a finite amount of time in which the owner has to rebuild the property as it was. Another, more concerning parameter is a damage threshold, which requires the owner to comply with the current zoning code in rebuilding the property if a certain percentage of the building is destroyed. Depending on the type of structure of the building, an especially limiting damage threshold could make rebuilding the property as a legal non-conforming structure very difficult.

Ordinance and Law Insurance

The best way to mitigate the risks posed by a damage threshold is by obtaining ordinance and law insurance. Unlike a normal property insurance policy, ordinance and law insurance provides additional coverage beyond mere repair of the damage by giving the insured additional resources to comply with the current zoning. Most insurance providers can provide ordinance and law coverage through an endorsement to the title policy.

Ordinance and law insurance can provide coverage in three different ways:

1. It will cover the cost of demolishing the undamaged portion of the property where a municipal entity may require the entire building to be torn down. An insurance policy without ordinance and law coverage might not cover the cost of such demolition.

2. Similarly, ordinance and law insurance will also cover the cost of rebuilding the originally undamaged, now-demolished portion of the property.

3. Finally, in the event that the local zoning code has changed since the time the property was initially built, the municipality may require the building to be rebuilt up to current code. Ordinance and law coverage will pay for such changes, whereas an insurance policy without ordinance and law coverage would only cover rebuilding the property in accordance with its pre-destruction form.

Conclusion

Zoning is a significant part of a commercial real estate transaction and should not be overlooked. It is important, both as a lender and as a buyer, to know where the property stands with respect to zoning so as to not run into any issues to could have easily been avoided. Additionally, best practice is to order a zoning report and obtain prop- er insurance if the property is classified as legal-nonconforming.

Rusty Fleming

Rusty A. Fleming is an attorney at Nelson Mullins Riley & Scarborough LLP.

Francis H. Kim

Frances H. Kim is an attorney at Nelson Mullins Riley & Scarborough LLP.