Financing Focus

Consider the Future When Negotiating Loan Document Details

After the basic business terms have been agreed on, proper negotiation and execution of loan documents can make or break a commercial real estate deal.

Whether acquiring an existing income-producing property, developing a new property, or refinancing the debt secured by a property, borrowers should pay attention to the details of their loan documents to ensure that future changes don't hinder their goals or ability to make decisions about their properties. Commercial real estate practitioners should understand how these issues could affect clients' transactions — or their own.

Several issues to consider in preparing loan documents include prepayment fees, assumption of debt, a change in the property's management company, and personal property leasing.

Prepayment Fees One vital loan document provision addresses what happens when the borrower-lender relationship ends. Borrowers should be aware of what will occur when their loan matures, or, more importantly, if it is paid before it matures. Most long-term, fixed-rate loans require a prepayment fee if they are paid off early. These fees typically decrease as the loan approaches maturity.

Borrowers should consider prepayment fees when determining loan terms. If a loan has a prepayment penalty, a window should exist when it can be repaid without a penalty. For instance, if a loan can be prepaid with no penalty up to 90 days before it matures, a borrower has flexibility in preparing to close on a new loan.

Prepayment fees come in many varieties, but two are the most common. A fixed prepayment fee is based on a fixed percentage of the amount being prepaid. Often implemented on a sliding-scale basis, fixed prepayment fees typically range from 5 percent of the prepaid amount in the early years of the loan to 1 percent of the prepaid amount as the loan nears maturity. 

With this type of fee, borrowers are aware of what would happen if interest rates change and they want to refinance a mortgage or sell a property before the maturity date.

Another common fee type, a yield maintenance fee, is not determined when the loan is made but is calculated when prepayment occurs. This type of fee is based on a formula that compensates the lender for lost income resulting from reinvesting the prepaid loan funds in an investment that yields less return than the loan. This fee does not offer the borrower the certainty of a fixed prepayment fee. However, if a borrower is not refinancing property, a yield maintenance formula could cost less if interest rates increase between the time the loan was made and when it is repaid. 

Assumption of Debt Many loans include the right to have a new borrower assume a loan, which is useful for buyers that wish to assume existing indebtedness of purchased property. Borrowers also can ask a higher price for their properties if the loan terms are favorable to assume. Loan assumption is subject to the creditworthiness, skill, experience, and competency of the assuming party, among other criteria. Borrowers should identify the appropriate criteria and require that the lender make a reasonable decision when approving an assumption of the loan.

Management Changes Potential borrowers provide lenders with background about the management of the property being financed, including the current management company.

If circumstances change, however, most loan documents do not give borrowers the right to make management changes without the lender's consent. Often, the lender has broad discretion about whether to allow changes.

Clearly, most borrowers want to retain total control over management. Some lenders will identify criteria that must be met for a change to occur, including the performance of the proposed manager at other locations and the manager's experience in the region where the property is located. The lender may impose additional criteria, including limits on management fees, so a change does not have a negative impact on the project's debt service coverage. Although the borrower must satisfy the criteria, this scenario may be preferable to having the lender make critical decisions about the property's operations.

Borrowers may want to consider suggesting specific alternate management companies that are acceptable to the lender. By remaining practical in negotiating criteria for management changes, borrowers can maintain flexibility in running their properties.

Leasing Property In some cases, it is more cost efficient for property owners to lease personal property — such as furniture, maintenance equipment, and decorative items — to use in business operations. 

However, most loan documents prohibit borrowers from leasing equipment used in basic property operations. A lender wants to know that if it forecloses on the mortgage, it will own what is required to operate the business. If the lender's security interest does not extend to leased property, then it would have to buy or lease its own property or take over the property owner's lease to continue to operate the property. 

The borrower does not want to be forced to buy personal property if it would be economically advantageous to lease it instead. Borrowers should try to negotiate provisions that restrict leasing items without the lender's approval. For example, borrowers could offer a cap on the amount of annual lease payments made for personal property or on the value of personal property that can be leased. They also could compromise with lenders by limiting leasing activities while obtaining some of the benefits a leasing program offers. 

Remember that the borrower-lender relationship extends beyond closing. When negotiating loan documents, seek legal advice to ensure that the proper issues are addressed so surprises don't occur in the future.

Mark Morris, JD

Mark Morris, JD, is chair of the real estate department at Fox, Rothschild, O\'Brien, & Frankel LLP in Philadelphia. Contact him at (215) 299-2828 or


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