SRA Standards Curb Due Diligence Uncertainty

With the intense competition to fund commercial real estate projects, the time frame for lenders to review loan packages and make a lending offer has been compressed. However, lenders’ duty to perform quality underwriting remains unchanged in the face of this time compression. Careful review of third party reports is an integral element of the underwriting process. Part of this process is the review of Seismic Risk Assessments (SRAs) for properties located in areas that are highly prone to earthquakes (seismic zones three and four). Until recently, SRAs were primarily performed in the West (California and portions of Oregon, Washington and Nevada). However, with enhanced interest in the New Madrid Fault, which encompasses portions of Mississippi, Arkansas, Tennessee, Kentucky and Illinois located along the Mississippi River, the evaluation of potential earthquake damage is receiving a higher priority in the due diligence process.

For properties located in earthquake zones three and four, lenders typically require an SRA. The purpose of the SRA is to examine the potential susceptibility of a commercial project to earthquake damage. For those properties that have a significant likelihood of sustaining earthquake damage of over 20% of the building’s replacement cost, most lenders require earthquake insurance to be in place for the full replacement cost of the building. SRAs express this potential earthquake damage in terms of a property’s Probable Maximum Loss or PML. In the industry, SRAs are often referred to as PML studies.

For properties with a PML of less than 20%, earthquake insurance is typically not required. Consequently, the results of an SRA determine if earthquake insurance is required by the lender for a building. For those properties with PML’s of over 20%, property owners typically perform a cost benefit analysis of purchasing insurance or retrofitting the building to reduce the PML to below 20%. Regardless of the route the property owner chooses to mitigate earthquake damage, insurance or retrofitting, the financial performance of the property will be negatively impacted by a PML of over 20%. Consequently, much is riding on the SRA’s results.

However, unlike other due diligence reports such as All Appropriate Inquiry, Phase I Site Assessments and others, a standard for the performance of SRAs has not been widely adopted. Unfortunately, the lack of widely adopted SRA standards has caused a wide variation in earthquake PML results. This problem has been attributed to the following factors: