Commercial real estate finance has changed dramatically, both in the sources and the terms of the finance. Still some fundamental patterns should be noted.
Terms: short term notes are used more by lenders. The lender may agree to a long term loan if the interest rate is allowed to float according to an inflation index or if the note contains a call provision entitling the lender to call in the note for repayment at a specified interval before the loan has been amortized. Lender may also participate in the income from the mortgaged property.
Sources: Insurance companies, pension funds and commercial banks are today’s major players in the commercial real estate finance.
There are 3 major entities playing in this field: limited partnership, the real estate investment trust (REIT), and joint venture. Limited partnership enables individual, high bracket investors to capture the tax advantages of owning improved, depreciable property. REIT also achieves the same goal for similar investors, but REIT operates much like a mutual fund, holding a pool of real property assets. Institutional lenders seeking an equity position in real estate will sometimes form a joint venture with a developer or other entrepreneur to build and operate the project.
Closing a mortgage loan transaction requires a number of documents. For complex financing transactions, attorneys make an extensive checklist to make sure all documents are in place, e.g., note purchase agreements, leases, assignments of leases, promissory notes, mortgages, financing statements, varies certifications, and detailed legal opinions. Among them, the promissory note is the most significant instrument, because this is the evidence of the indebtedness and the promise to repay the loan. Only one copy of it should be signed by the borrower.
Developers/investors are primarily interested in the following aspects of a mortgage loan,
- The amount of the loan
- The interest rate
- The term to maturity
- The repayment provisions
- The prepayment provisions
To prevent loan default, promissory note frequently incorporates following devices,
- Due-on-Sale provision
- Prohibition against junior financing
- Option to call
- Option to recast
Lender will also write default provisions to prevent loss, such as accelerate payment provision and liquidated damage provision.
Currently, the majority of loans on commercial property are non-recourse loans, which means that the borrower has no personal liability. This is achieved by using exculpatory provision. Care must be taken to draft this provision.
Mortgage – Construction Finance
The lender who finances a construction faces a riskier, more complicated task. This is because the construction lender must base its appraisal on pieces of paper – project plans, specifications, and income projections. The lending industry has resolved this risk and complexity by dividing development finance between a construction lender – who makes short term, floating rate loans – and a permanent lender – who makes long term loans.
The construction lender will advance the funds by stages over the course of construction, with its loan secured by a first lien mortgage on the property. The permanent lender will “take out” the construction mortgage upon the completion of the construction, by replacing the construction mortgage with a long term mortgage.
Leases – The Ground Lease and leasehold Mortgage
While a ground lease is a lease of land, it is usually much more than that and it differs fundamentally from the usual lease of space in the following aspects,
- The improvements on the land, called leasehold improvements, usually are owned by the lessee.
- Ground leases are customarily “net,” means that the lessee pays almost everything. Lessor’s position is similar to that of a secured lender in many ways.
- Long term is the mark of the ground leases. Rarely is the term less than 35 years.
- The needs and requirements of the institutional lender must be anticipated by both lessor and lessee.
- A ground lease is best understood not by lease terms, but as a financing device.
Leases – Sale-Leaseback
The sale-leaseback is a financing vehicle which enables the developer to minimize his equity investment in a property. Conventional mortgage financing is generally limited to a 75% loan-to-value ratio. This ratio can be exceeded by the use of a sale-leaseback in addition to a mortgage loan. In its barest elements, the sale-leaseback is a comparatively simple transaction. The owner of a parcel sells it to an inventor and simultaneously leases it back under a long-term net lease. This lease imposes on the lessee virtually all of the obligations and substantially all of the benefits of ownership.