A Primer on Loan Docs
This document is meant as a baseline to help TermSt.’s clients understand what they are signing up for when they enter into a transaction with one of our lenders. What you should realize is that no set of loan documents is ever the same. No matter how many times you’ve negotiated loan documents you can always do better on the next. This is merely some simple help on the some of the most highly negotiated points that I have dealt with during my career spanning hundreds of transactions and over $7 billion in total transaction volume in commercial real estate finance. You should always have an experienced attorney knowledgeable in commercial real estate finance. We have some exceptional referrals that have been vetted for practicality and efficiency. We’d be more than happy to make a referral that will help save you some time, money, and headache.
First off, what all borrowers should know is that you are paying for your lender’s legal bill. So staying practical in your requests will save you time and money. I’m not saying you should not negotiate for what’s important to you, just understand that you are paying for your counsel and your lender’s. Another critical point to understand is that the time clock for lender’s counsel does not typically start spinning until after the application has been signed. The more you can negotiate as part of the application or term sheet, the less time will need to be spent negotiating the loan docs. Spending time getting things right up front, will save you money on the back end.
Which brings me to the application. What is the loan application? While many borrowers believe this to be a two-sided document that commits a borrower and lender to doing business together, that is actually quite wrong. A loan application generally commits a lender to very little. It is merely a document that lays out the general terms under which a lender may be willing to make a loan if they still like the deal after their due diligence. During the due diligence they are going to dig in to the borrower and the people behind it, the management company, the physical property, the tenants, and the financials. If after all of that review, they still like the deal, then they will commit to you to make the loan – typically a day or two before actually closing. This is important to know when negotiating the loan application. Particularly related to the fees and the refundability of the fees and good faith deposit. The lender is certainly going to expect the fees and deposit to cover their actual out of pocket costs. That said, if the borrower acts in good faith to close a loan and the borrower chooses not to close the loan after due diligence, they should refund the portion of the fees and good faith deposit in excess of the actual out of pocket costs. Negotiate for this in the loan application.
Enhance Your Opportunity for a Smooth Process?
There is really one way to enhance your opportunity for a smooth process up front. The worst thing a borrower can do is to knowingly hide something that could potentially be an issue for the lender. I’ve seen this many times. A borrower does not disclose a past foreclosure, bankruptcy, felony, physical issue at the property, environmental issue at the property, or such other issue at the property under the belief that the lender will not figure it out. None of these things is a complete show stopper if disclosed, but if your lender finds it out without the borrower disclosing the issue, it is going to lead to judgement of the moral character of the borrower. This is not a good way to start a business relationship and more often than not, leads to a failed loan closing. At TermSt., our application asks you to disclose past borrower or property issues. Help yourself and your new lender by providing a complete disclosure of those issues that might create issues with the loan underwriting and enhance your chance of closing your loan.
To Rate Lock, or Not to Rate Lock
This is not an easy question. When you lock a rate, the lender typically requires a deposit of 2% of the loan amount or more and they execute a hedge against movement in interest rates (life insurance companies probably do not hedge, but they enforce these provisions as if they did, which may or may not be fair. Call me to discuss that one.) If the loan fails to close, or if the loan proceeds are cut prior to closing, there may be a breakage event under the hedge. If interest rates have gone up since the rate lock, the hedge will be out of the money, and the lender will require that you make up for the cost of the breakage out of the rate lock deposit. This can be quite costly.
Rate locking is an important way to protect yourself from the risk of rate movement. Sometimes a rate lock is the only thing saving an acquisition if rates increase significantly. You just need to be careful and understand your risks.
Talk to your lender or broker and try to understand what could still go wrong in the process. How much of the due diligence have they completed? Have they reviewed third party reports? Does the loan Application include a Material Adverse Change clause that allows the lender to reject the deal if there is a major change in the real estate or capital markets environment. A good mortgage broker or lender can help you make this decision, but it is almost never risk free. Generally speaking, you are safe to rate lock with a life company or agency lender and would need to be more careful with a CMBS or non-bank lender.
I have existing third party reports, can they get used to save money?
Were they completed in the last 6 months and were they engaged by a lender that will assign the reports? Then the chances are good that your new lender can rely upon those existing reports. Always ask a lender if they can utilize your existing reports. Worst case they say no.
I have a bunch of investors in my deal. Does my lender care about them?
The answer here is yes and no. Lenders care about the company and people that are making the day to day decisions at the property the most. Lenders also have a preference that these companies or individuals have a strong balance sheet and are investing a reasonably significant portion of the equity in the deal (usually 10% of the equity or more). That said, lenders want to know that if something goes wrong at the property, someone is going to be there to cover potential shortfalls in debt service and to cure problems at the property. If this is not the case for those individuals with day-to-day control a lender may look through to the limited partners to find that financial strength and may require that the individuals with the financial strength sign on as additional guarantors.
In general, most lenders will want to run credit and background searches on any investor that owns 20% or more of the membership interests in the property, so prepare your investors that they may need to sign some paperwork to accommodate these searches.
Lenders typically try to limit transfers of ownership interest. If you have a significant number of investors, they should understand that this is likely an illiquid investment and they may not be able to sell their interests if they determine they’d like to down the road. Transfer provisions are negotiable though. Most lenders will allow for transfers of interest of 20% or less without lender approval (although you will likely need to provide notice of the transfer). You likely can get a lender to approve transfers of interests of non-gurantors, so long as the guarantors still control at least 20% of the equity interests in the property and control all day-to-day and major decision making. Transfers become more problematic when key principals of guarantors want to transfer their interests. This is generally considered a change of control transfer and a lender will likely want to charge of fee for review and approval of the transfer and potential replacement of the guarantor. The approval of this type of transfer is also likely to take 30-60 days or more, so be prepared for that – and the servicer is going to request a significant amount of information on the parties involved.
If you are contemplating a potential transfer of equity interest of a key principal or guarantor in the near future, try to make the transfer before closing on the new loan or get the transfer pre-approved. It is always easier to get something done when everyone is friends during the loan origination process than afterwards when the loan is controlled by the servicer.
Tax and Insurance Escrows
Many loans require tax and insurance escrows. What this means is that the lender collects 1/12th of the annual estimated tax and insurance expense with each monthly payment. Most borrowers understand this, but what they do not always understand is how the amount to be escrowed at closing is calculated. This sometimes causes a cash shortfall during the week of closing that must be overcome. With a little negotiation this can be prevented.
The trouble is that most lenders typically pay the real estate tax bill 30 days prior to when it is due and required that the funds to make the payment are available in the escrow account 30 days prior to that. Typically this means that the escrow account is required to be overfunded by about 60 days. This can be a big number. Also, if the tax bill is due soon, you may be required to escrow almost a full years tax payment. This often does not make it into a borrower’s estimation of cash needs at closing.
Reserves for Tenant Improvements, Leasing Commissions, and Capital Needs at the Property:
One of the biggest complaints that borrowers have with their lenders is the difficulty in getting the lender to release funds from the various reserve accounts to pay for tenant improvements, leasing commissions, and other capital needs at the property. Lenders typically require photos of completed work (maybe even an inspection), invoices, cancelled checks, lien waivers, and other such proof of completion and payment before they will release funds from the escrow accounts. If you have large escrows, this is a particular area to have your attorneys focus on in the loan application and loan documents. Lenders may be willing to relax their requirements for all work to be completed prior to a release from the escrow for large projects. They may also be willing to issue a two party check to a contractor and the borrower which ensures the money gets to the contractor and cannot be misappropriated by the borrower for another use. This would allow a lender to make a funding from the escrow prior to proof of payment and help a borrower with cash management.
Particularly for long term, fixed rate permanent loans, it is important to have loan assumption language in the loan documents. These loans may have substantial prepayment costs which would make it nearly impossible to sell the property down the road without a loan assumption. These provisions can sometimes be somewhat overbearing depending upon the lender requiring a strong borrower and strong property performance at the time, but you are making a mistake if you do not attempt to get these provisions in your loan docs. Frequently the lender will require a transferee to have a stronger balance sheet and stronger management background and that the LTV is lower than at origination and the NOI is higher. If you have these provisions in your loan documents there is more likelihood that the servicer will play ball when you do elect to sell. This is particularly important for a CMBS loan. If you do not include this optionality in your loan documents, it is unlikely that you will even get a servicer to engage with you in a conversation about a loan assumption.
Various Lender Approvals
There are going to be various provisions in the loan documents that require lender approval, whether it is for executing new leases, completing capital improvements, or executing on a transfer of interests. It never hurts to try to get deemed approval language after a certain period of time. Usually 45 days is a fair deemed approval timeline. Often times a lender will want very specific notice prior to the deemd approved deadline. They may require a letter with language like the following:
“On October 1, 2018, Borrower sent lender all of the requirements for the approval of a Major Lease. Per the terms of the Loan Documents, the Major Lease is to be deemed approved 45 days after initial notice to lender. The deemed approval date is 15 days beyond the date of this letter on November 15th.”
This is likely only available to borrowers with large loans, but it is good for all borrowers know understand what is potentially available.
Near Term Approvals:
Before finalizing your loan documents, make sure you have everything approved that you know you’d like to complete in the near term. This includes things like capital improvements, equity transfers, leasing activity, moving tenants around, removal of a land parcel from the collateral, granting a new easement, or such other physical or legal activity that is in works. It is always easier to get these things approved at the time the loan is originated rather than waiting until it is in the hands of a servicer.
Another frustration with borrowers is the time it takes for a lender/servicer to approve of leases. Some of this frustration can be resolved by good negotiation of the loan documents. This is an area to make sure you have your counsel focus on. A lender is typically going to want to review and approve all leases above a certain threshold. Typically this is any lease that makes up more than 10-15% of the total square footage or gross potential rent at the property. Try to stretch this figure as high as the lender will allow. Also consider outlining lease terms under which a lender/servicer will use to make their evaluation. This should include 1) quality of tenant credit (at least as good as the prior tenant, or commercially reasonable), 2) minimum base rental rate, and 3) minimum lease term. Try to take as much of the actual decision making out of the servicers hands so that the lease approval becomes more of a lease review.
Servicers are profit centers for lenders and they typically run them as such. Servicers will have their hand out for a fee almost every time there is an approval required. These fees are typically negotiable in the loan documents so work to get the fees pre-negotiated rather than leaving it up to the lenders discretion at a future point in time. At a minimum, ask them to attach their current schedule of fees to the loan documents.
Again, getting near term items pre-approved is a good way to prevent some of these fees.
Future Supplemental Loan or Mezzanine Financing:
This is something that most lenders do not like to agree to up front but may be willing to talk about in the future. Even if the loan documents do allow future subordinate financing, the provisions surrounding this future financing will be incredibly vague and favor the lender, but if it is important to you, it does not hurt to have it included in the loan documents. Certain lenders have future financing programs, in fact Fannie Mae and Freddie Mac have some of the best supplemental loan programs around, so take advantage of them when you can.
Most fixed rate loans are going to have some sort of prepayment penalty attached. This will either be in the form of a fixed prepayment amount, a yield maintenance calculation, or defeasance. We have blogged about the difference between yield maintenance and defeasance and how to choose between the two of them here. The biggest factors that borrowers could negotiate, but do not, is the open period, and whether the defeasance or yield maintenance period is calculated through the open date or through maturity. Many times lenders can offer longer open periods (at a cost of a higher spread). Addtiionally, most of the time, the initial language you find in the loan documents calculates the prepayment premium through the maturity date of the loan rather than the date the loan becomes open to prepay at par. If I have paid an open period, why would I ever pay to prepay through maturity? It has never made any sense to me. On some CMBS loans, this is a pure profit center to the servicer. They do not pay this excess yield to the bond holders. Just a little dirty math.
A trick, ask your lender if you might be allowed to elect between defeasance or yield maintenance at the time of the prepayment rather than in the loan documents.
While most lenders do a poor job of tracking what they have in their servicing file until something goes wrong, they do maintain the ability to collect monthly, quarterly, and/or annual reporting on the property and its financials. The list is generally extensive and failure to comply comes with a costly penalty. Make sure this list is fair and the amount of time given to provide such documents is inline with your accountants preparation schedule. Additionally, attempt to limit as much of this list to “as requested by lender” instead of an on-going requirement. I think you will find that most lenders will not require much unless the property is not performing well. Also, negotiate for a waiver of the late fee once or twice during the term of the loan.
Replacement of Property Manager:
One provision that is included in many lender loan documents that gives me heartburn is the Lender’s right to replace the property manager based upon a certain debt service coverage ratio. If your property falls to a 1.0x or even 1.15x DSCR, these lenders want to fire your manager and bring on a manager of their own, even if you are still making your payments. Push back on this requirement such that the lender only has this right upon a monetary event of default.
Personally, I believe a lender that actually utilizes this clause to fire your property manager is opening themselves up to liability to the extent it causes economic or physical harm to the property, but lenders do not always think to hard about this.
Single Purpose Entity (SPE Provisions)
Most loans these days are going to require that the borrower be a single purpose entity and may take it one or more steps further. They may require that the entity be a dual member entity or domiciled in Delaware (these are generally easy and inexpensive to deal with). For larger CMBS loans, usually over $20 million, they may require a non-consolidation opinion ($10-20k legal cost), and for even larger loans, usually $30 million+, a lender may require the entity to bring on one or more independent directors whose vote would be required for a bankruptcy filing at the entity level.
All of these provisions are meant to separate the real estate collateral from any outside risks that are more difficult for a lender to underwrite. These are only negotiable to a certain extent and will be more prevalent with CMBS, bridge, and non-bank lenders. Life Insurance companies have more flexibility in these provisions.
Following up on the requirement to have the real estate collateral owned by a single purpose entity, the question arises as to whether a borrower can use their existing entity as the borrower for their new loan for a refinance. Most of the time a borrow would prefer to “recycle” their existing entity to mitigate any additional costs related to recording tax, transfer tax, or triggering a reassessment of the property. Most of the time a lender will work with a borrower to recycle an existing entity. The only time this may not be possible is if there has been some sort of negative event at an asset owned by that entity that could cause liability going forward. This could be some sort of major HR event, an environmental issue at a property previously owned by the entity (entity used in a 1031 exchange), or other major litigation or prior bankruptcy filing.
If the entity has only ever owned this one property and there has been no major litigation related to the property, it is probably a pretty good bet that a lender will allow the entity to be recycled.
Also, to the extent possible, it is good practice to have employees employed by an entity other than your borrowing entity in order to protect the single purpose status of your SPE for the loan term.
A Subordinate, Non-Disturbance, and Attornment Agreement (SNDA), is an agreement between a lender and tenant. A lender typically requires that a tenant’s lease be subordinated to the mortgage. In exchange for this subordination, a tenant typically gets non-disturbance language, meaning that the lender will recognize the lease after a taking event (foreclosure, deed-in-lieu), and the tenant agrees that they will recognize the lender as the owner after any such taking event.
In reality, most leases are subordinate to the mortgage by their nature and SNDA requirements are often waived by lenders unless the lease is materially important to the property (represents in excess of 20%+ of the leasable area or gross potential rent) or the lease contains some troubling provisions such as a purchase right or the lease is recorded.
Part of a lender’s due diligence is to gather estoppels from each of the tenants at a property. An estoppel is a document executed by the tenant that lays out the basic provisions of their lease as they understand it so that a lender can confirm that those terms match the rent roll and the leases provided to them. Many lenders will set forth a requirement for a borrower to obtain estoppels form some percentage of the tenants at the property (eg. tenants representing 75-85% of the gross potential rent). However, other lenders (CMBS lenders in particular) will typically require that the borrower attempt to gather estoppels from all of the tenants. CMBS lender make certain reps when they sell the bonds related to their deals and one of these reps is generally that they required their borrower to attempt to get 100% of the estoppels. There is always some flexibility on the percentage of estoppels that are acquired, but some lenders force a borrower to get a waiver closer to closer creating some risk to the borrower.
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