It's a common scenario: The zoning of the property being financed does not match the property's use. It may seem minor, but if you don't know the basics about zoning, you may soon see a major roadblock on the path to financing a property.
What is zoning?
Zoning promotes compatible land use within a city's limits. Generally, it keeps residential properties in residential areas and commercial properties in commercial areas. It also gets more specific than this, though. Zoning encompasses a building's height and composition, signage, number of stories, parking spaces, and so on.
An area's zoning can change over time. For example, as a city grows outward, it may impose zoning on areas that did not have zoning requirements previously. A growing city may also change an area's zoning to fit its needs. For instance, an area that once was zoned as residential may be rezoned into light-commercial usage (e.g., small office or small retail as a city's commercial district expands).
When zoning changes
Legally, a zoning change can be handled in a few ways. The most common option is to have the property owner change the use of the property to match new zoning.
In most cases, a property will be rezoned to a more "valuable" use. For instance, a property that was originally zoned as residential and is rezoned as light-commercial usage now has the value of the land and the square footage of the building being valued as commercial property.
But changing a property's use to match current zoning is not always feasible. Therefore, municipalities have the option of invoking a "grandfather clause" to give a property owner the right to use the property for its previous use. These properties are also known as "legal nonconforming."
There are some rules to keep in mind about the grandfather clause. First, to qualify, the property must have had a legal use before the new zoning change went into effect.
Second, if the property is partially or fully destroyed, the property owner will only be allowed to rebuild the property according to current zoning. For example, if the residential property that was rezoned into light commercial burns down, a building permit would only be granted to build a light commercial-use property in its place. A residential property would not be allowed to be rebuilt.
Likewise, any new additions to the property must match current zoning. With this same example, if the property owner wants to build an addition to a house to increase square footage for its residential use, a building permit would not be granted. If the property owner wants to add a storefront to the house and turn it into a mixed-use property, however, the permit may be granted. Any additions to the building must move the property toward conforming to zoning requirements.
How does this affect financing?
Although it seems as though single-family homes will always qualify for residential financing, this isn't always the case.
A lender will consider the property's current use and its potentially required future use. Therefore, a residential lender may find it too risky to lend on a property that may not be permitted to be rebuilt as a residential property.
Then you should apply for commercial financing, right? This is not necessarily the case. In many states, a commercial lender will not lend on a residential homestead, regardless of whether the property is zoned as "commercial." In some states, however, some commercial lenders may consider financing a commercially zoned single-family residence, regardless of use, if a corporation owns a property.
This Catch-22 presents a challenge. Zoning requirements vary by municipality and by lender, so there is no simple, universal solution to financing a nonconforming property.
Not all zoning changes present a financing challenge. For instance, if a single-family home has been rezoned to two- to four-family zoning, the property could still fall under residential guidelines and may qualify for residential financing.
While you have options to help you get over these roadblocks, flexibility and forethought are key to navigating them. Ensure that you are aware of a zoning situation, and pro-actively stay up to date with all of the moving parts.