Documentation on real estate loan transactions has grown exponentially over the years. The days when a borrower would sign a one-page promissory note and a two- or three-page deed of trust are long gone. Today, commercial real estate loan documentation includes hundreds of pages of documents. In addition to the note and deed of trust, a loan may include loan agreements, environmental indemnities, access laws indemnities, assignment of contracts, security agreements, financing statements, and guaranties. Borrowers often respond to this onslaught of documentation by not reading the documents, and not even hiring an attorney to do so. Instead, they simply cross their fingers, close their eyes, and sign on the dotted line. This behavior seems to be more prevalent when the loan documents are on preprinted forms. In such instances, borrowers are apparently comforted by the thought that because the forms are printed, the terms are not negotiable and everyone signs them as is. The truth is that many clauses in loan documents are negotiable to one degree or another and that failing to read the documents, hire an attorney, and negotiate appropriate changes can result in serious problems for a borrower down the road. This article will discuss some of those problems and how a borrower can avoid them by obtaining more favorable terms in the loan documents.
Prepayment Fees
Nearly all real estate loans that carry a fixed interest rate provide for the borrower to pay a fee if the loan is paid before its maturity. The fee is designed to ensure that the lender receives the agreed-upon rate of return on its investment. Years ago, the fees were easy to understand, such as 1 percent of the amount prepaid; today, however, the fees are generally stated in complex mathematical formulas that even a sophisticated borrower often cannot comprehend. Borrowers should be aware that such formulas can produce extremely large fees when rates decline between the date of signing of the loan and its payment—sometimes as much as 30 percent or more of the principal amount of the loan, depending on how early the loan is prepaid. In light of this, borrowers should consider the following:
- Some lenders will agree to remove the prepayment fee entirely if the interest rate on the loan is increased a few points.
- The mathematical calculations for prepayment fees are not all the same. They tend to fall into two categories: “break funding” calculations and “yield maintenance” calculations. A yield maintenance calculation will generally produce a much larger prepayment fee.
- Some clauses include a provision whereby prepayment is actually prohibited for a period of time, known as a “lockout period.” Consider whether such a provision would interfere with your plans to develop and sell the property.
- Many lenders will agree that the prepayment fee is not payable upon a prepayment that results when insurance or condemnation proceeds are applied to the loan.
Due-on-Sale Issues
“Due-on-sale” clauses provide that the loan will be immediately payable in full if the real estate is sold without the lender’s consent. These clauses are often drafted extremely broadly and also prohibit transfer of any interest equity in the borrower. If requested, a lender may allow an exception for transfers of a minority interest, as well as a transfer to a trust for estate planning purposes and transfers upon the death of a member in the borrower, so long as key individuals remain in control. A borrower may also be able to negotiate a one-time exception to the due-on-sale clause that will allow the borrower to sell the property to a purchaser who assumes the loan and who is acceptable to the lender.
Secondary Financing
Most commercial loan documentation prohibits the borrower from placing a second priority lien on the property. This provision, coupled with a prepayment penalty, may preclude a borrower from tapping into equity in the property for a number of years. A borrower may be able to negotiate a provision that allows a secondary lien if the borrower demonstrates that the cash flow from the property is sufficient to cover the debt service on both liens. At a minimum, the borrower should ensure that the loan documentation does not prohibit a mezzanine loan, which is a loan that is not secured by the property but rather is secured by a pledge of an equity interest in the borrower.
Lease Approval Issues
In most commercial real estate loans, the income from leases at the property is the primary source of payment of the loan. Accordingly, lenders will often include provisions that restrict the borrower from entering into new leases, modifying leases, or terminating leases without the lender’s prior written consent. Such restrictions can be a burdensome operational issue, particularly for multi-tenant properties. If requested, many lenders will agree that only major leases will be subject to such restrictions. A major lease is generally defined as a lease covering a certain size of premises or percentage of the rent for the project.
Material Adverse Change Clauses
An attorney representing a borrower will attempt to avoid clauses that state that if the borrower or project suffers a material adverse change in its financial condition or if the lender deems itself insecure, it is an event of default such that the loan may be accelerated. While in reality lenders rarely invoke such clauses, the inclusion of the clause can provide the lender with leverage in subsequent negotiations.
Insurance and Casualty Issues
A number of issues can arise under real estate loan documents in respect to casualty insurance and loss. Here are a few rights that a borrower should attempt to obtain in the loan documents:
- The right to settle with the insurer and receive insurance proceeds is generally assigned to the lender but a borrower may be able to negotiate a provision that allows the borrower alone to handle such matters for losses below a certain dollar amount.
- Loan documents will generally provide that following an insured loss, the lender may either apply the insurance proceeds to pay the loan or allow the proceeds to be used to rebuild. Many lenders will agree to allow the borrower to use the insurance proceeds to rebuild, subject to satisfaction of certain conditions, including the following: (1) if insurance proceeds are not sufficient to rebuild, the borrower must deposit the difference; (2) key tenants will remain in occupancy and do not have the right to terminate their leases as a result of a casualty; and (3) after restoration, the amount of the loan will not exceed a certain percentage (usually 70 percent) of the value of the restored property.
- If the borrower is successful in negotiating the right to rebuild with insurance proceeds, the borrower should also negotiate for provisions that will allow insurance proceeds to be disbursed as construction progresses (subject to typical controls used in construction loan documentation), rather than being held by the lender until the project is completely rebuilt.
- The borrower should also carefully compare the insurance provisions in the loan documentation with the insurance provisions in its leases. If the loan is secured by a property with a single credit-tenant lease, the lender may be willing to adjust the loan document insurance clauses to accommodate the provisions in the lease.
Partial Releases
If the borrower’s plan of development calls for sales of portions of the property, such as the sale of a pad, a provision should be negotiated that allows release of the pad from the deed of trust upon payment of a portion of the loan. A borrower should confirm that this does not trigger a prepayment fee or fall within a lockout period.
Death of Guarantor
It is common for real estate loan documentation to provide that the death of a guarantor is an event of default. Lenders have a legitimate concern in this regard, but borrowers understandably do not want to have the loan accelerated when it is not otherwise in default and the property is fully performing. A borrower should negotiate for a provision that allows the borrower to cure a default arising from the death of a guarantor by providing an equivalent substitute guarantor who is acceptable to the lender. This may be as simple as having the right to have the spouse of the deceased guarantor, assuming the spouse is receiving substantially all the assets of the deceased guarantor’s estate, guarantee the loan.
Late Fees
When a payment is not made on time, loan documentation will generally provide that the lender can assess a late fee. A borrower should request a grace period before the late fee may be imposed. Five days is common. The amount of the late fee also varies significantly from lender to lender and may be subject to negotiation as well. A borrower should make sure that the loan documents do not call for the late fee to apply to any balloon payment under the loan.
Notice and Cure for Default
In addition to making timely payments on the loan, loan documentation imposes myriads of obligations on a borrower, from the timely payment of taxes to proper maintenance of the property. A borrower should negotiate for a provision in the loan documents that requires the lender to give notice and a reasonable opportunity to cure an alleged default (assuming the default is curable) before the lender declares the loan to be in default.
Conclusion
Despite its voluminous nature, a borrower is well served by closely reading commercial real estate loan documentation and hiring a competent real estate attorney to provide advice. Not only will such an attorney be able to spot issues that a borrower may not see, but the attorney will know which issues may be subject to negotiation to a more favorable position for the borrower. A proactive approach by borrowers on commercial real estate loan documentation requires a bit more effort and costs up front, but will pay dividends in the long run by avoiding potentially significant problems.
For further information about commercial real estate loan documents, contact Jonathon Goodling at (503) 205-2522 or at jon.goodling@millernash.com.
