Financing Focus

Borrower Beware(1)

Learn how to manage risk during the loan application process.

Most commercial mortgage lenders charge application, due diligence, and loan commitment fees, but do your clients know what that money really is buying? Often, it is less than they think.

The loan application process is becoming increasingly arduous as lenders adopt more numerous and subjective requirements and procedures. Though this is particularly true in permanent financing transactions, it is becoming more applicable in short-term financings from local and regional lenders as well. Many loan commitments do not really obligate or commit lenders to fund until closing, and borrowers often underestimate the importance of managing this risk.

Commercial real estate professionals must fully understand loan application terms and the extent of the lenders' and borrowers' commitments to help clients successfully manage risk and limit losses.

Reduce Risk With These Tips Several key strategies help borrowers handle risk during the mortgage loan application process. Planning ahead for an early closing certainly is one of the best. Following are five others.

Create Laundry List Exclusions. A very cost-effective method, especially if a borrower often applies for similar loans, is to develop a list of conditions lenders will not require prior to closing. Attached to loan applications or commitments, this rider narrows the scope of lender contingencies and reduces surprises in loan documents received late in the process. Of course, lenders will vary in their acceptance of these limitations. However, as borrowers apply for more loans of a similar nature, their track records in obtaining acceptance of these limitations will give them added ammunition in new loan applications.

The list should include requirements such as the following:

  • Loan documents will not contradict specific application and commitment provisions. (Borrowers should make sure all major loan terms are itemized correctly and in detail.)
  • The lender will not require amendment of property leases, except as specified in the subordination agreement, or make the lease enforceable if it contains fatal defects or specific problems such as unsubordinated purchase options or rights of first refusal to purchase the property.
  • The lender will accept the original guarantor(s) specified for carve-out guaranties, unless a material change in their financial condition has occurred since the application was accepted.
  • The lender will not prohibit certain types of transfers, such as transferring non-management equity interests.
  • The lender will not require the borrower to eliminate nonconforming uses under currently grandfathered zoning or building laws.
  • The lender will not require the borrower to have independent managers or directors (related to requirements making bankruptcy filing by the borrower less likely).

Delay At-Risk Money Pending Satisfaction of Certain Requirements. If the application requires that specific conditions must be satisfied that are largely or completely outside borrowers' control ? such as obtaining subordination of a tenant's purchase option, obtaining a variance from an ordinance, or obtaining consents and agreements from adjacent property owners ? borrowers can choose one of two strategies. They simply can delay making application or require that certain portions of their deposits and fees be refundable pending satisfaction of certain unpredictable conditions. At a minimum, borrowers may be required to pay the lender's legal expenses for analyzing satisfaction of these threshold contingencies.

Prohibit Escape Clauses for Lenders That Could Gut Non-recourse Provisions. Borrowers should not allow nonrecourse provisions to be included in summary terms that leave significant details up to the lender's discretion. Require that the following are attached to the application in exactly the terms to be used in the loan documents: detailed nonrecourse provisions, nonrecourse carve-out liabilities that individual principals or substantive corporate affiliates typically guarantee, and related clauses, such as single-purpose entity requirements. Doing so allows borrowers to veto objectionable provisions, such as unreasonable carve-outs or full-recourse triggers for events including borrower insolvency, borrower failure to comply with certain SPE provisions, such as adequate capitalization or solvency, or the filing of involuntary bankruptcy against the borrower. Borrowers might be required to pay lenders' attorneys for negotiating these provisions, but it is money well spent.

Require Lenders to Commit; Create Borrower Outs. Many loan applications do not mention the lender's acceptance of the application or issuance of a separate commitment. They often state that borrowers must pay nonrefundable commitment fees when the lender's loan committee approves the loan (no matter how many conditions and contingencies remain). Borrowers should insist on clear requirements for lenders to accept loan applications or issue separate commitments by a specific date; otherwise they can walk away forfeiting only certain specific fees and out-of-pocket expenses.

Borrowers also should negotiate clear outs at certain points in the process with fixed exit costs if lenders do not sign off on certain contingencies.

Modify Satisfaction Conditions. Borrowers should strive to eliminate provisions under which lenders may refuse to close based on general market conditions that they determine to be relevant to making loans. Minimize other lender satisfaction clauses and make the conditions objective in nature. Where not able to eliminate them, make clear that failure to show objective reasons for backing out of the commitment results in a refund of all major fees and, possibly, certain due-diligence expenditures that are not useful in applying for another loan.

Remain DiligentLenders can word loan commitments in ways that make borrowers liable for failure to accept loans, and that exposure may be in excess of a borrower's deposits and hedge costs. In some circumstances, lenders might be entitled to specific enforcement of their rights to make loans. Borrowers should eliminate these types of provisions wherever possible.

The amount of leverage borrowers have in utilizing these strategies varies. However, the application is the time to negotiate.

With lenders currently adopting stricter risk management policies, borrowers have to address their own risks as well. Otherwise, the costs, in terms of both money and frustrated closing expectations, could be very high.

Jonathan A. Peckham

Jonathan A. Peckham is an attorney with Boyar & Miller in Houston and serves on the Houston Bar Association's Real Estate Law Section board of directors. Contact him at 832.615.4252 or jpeckham@ boyarmiller.com.

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