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Condemnation of property – also known as eminent domain – has never been high on the list of real estate business priorities. However, in tough economic times, eminent domain cases should be carefully analyzed, especially when they involve distressed real estate.

In good times, lenders and investors holding security on real estate typically step aside and let the property owner/borrower deal with eminent domain litigation — that is, unless the taking is so large in scope it wipes out the secured property interest, in which case the lender typically gets the first dollars recovered to pay off the loan. Usually, both the property owner and parties holding security in the property are formally named in the condemnation lawsuit, but the approach of many lenders, particularly for partial takings, is to let the property owner run the show. Condemnation and appraisal can be complex, especially regarding income-producing properties; typically, security holders focus on the loan's health rather than the opportunity for the property owner to receive additional just compensation for the taking. At most, mild negotiations are held about an equitable allocation of such recovery.

When markets turn for the worse, the same bank or investor representatives who have passively monitored condemnation actions affecting their portfolios suddenly are deluged with new and greater concerns; this further dilutes their attention spans concerning underlying litigation involving the borrower. When the circumstances are right, condemnation cases affecting property held as security can become the proverbial “gift horse” for the savvy lender or investor.

Informed lenders and investors should work hard to shed the historic pattern of neglecting such cases and get actively involved early in the process. Secured parties’ rights in such cases are driven by the terms of their loan and participation agreement affecting the asset. Secured interests are almost always recorded as a lien on the condemned property; however, in more complex financing transactions, that is not always the case. Parties with a contractual interest in proceeds from a sale of property often have the right to intervene in condemnation actions to assert their interest, even if they are not initially named. Many agreements give the lender the right to call the shots in the condemnation case, including retaining counsel and experts, and deciding whether to settle early or push for a larger recovery — and a longer litigation process. This is where carefully crafted condemnation clauses in loan documents can pay big dividends in down times.

Sometimes secured parties are so desperate for quick cash flow that they are inclined to grab the initial offer by a condemning authority to close the case out. A condemnation cash settlement may provide cash flow where little may currently exist, and a quick settlement avoids investment in attorneys’ fees and expert costs attendant to the litigation process. By doing this, however, many lenders are stepping over large dollars to pick up pennies. In most condemnation actions, it is wise to engage skilled property owner condemnation counsel to carefully consider whether the initial offer by the condemnor is close to the full and fair compensation that would be recovered if the case proceeds to trial.

Such concerns are especially crucial when only part of a property is taken in the condemnation. Let’s say the secured asset is a corner convenience store with two covered gasoline dispenser islands. The condemning authority needs to add a right turn lane along a roadway fronting one side of the property and an overhead transmission line easement along the other. Many initial condemnor offers are based on the premise that there is no “severance damage” to the property, which is defined as diminution in value to the remainder after accounting for the part actually taken. Often, such seemingly innocuous takes can result in future setbacks and parking impacts on the property that could cause it to lose its gas dispenser islands and even its front parking, changing the highest and best use of the property to a much less intensive, and therefore less valuable, use. Severance damages can total much more than the value of the property that is taken. If a case is settled early on, property owners and lenders have waived their claim for damages that are encountered in the future. If the security has been greatly devalued without payment of full just compensation, both the property owner and lender lose.

In tough economic times, banks and lenders should allocate their resources to pay more attention to often-ignored condemnation cases. Those that fail to do so may be passing over the best source of cash flow and equity to restore a loan to good health that may exist in a marketplace when standard revenue sources have dried up. Whether the secured property is at the front end of a foreclosure process or is already in the lender’s real estate owned portfolio, secured parties are best advised to keep their eye out for this modern gift horse of revenue. Casting off historic practices and instead investing additional resources toward recovering full just compensation, where the documents give the lender such rights, will usually be repaid several-fold in the condemnation process.

— Steven A. Hirsch is a partner in Bryan Cave LLP’s national real estate litigation practice.

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