by David J Lewis
Many aspects of negotiating a secured real estate loan in the US will be unfamiliar to the British property investor. Yet almost all foreign investors in US real estate will want to borrow from a US lending institution. The fourth article in this series on legal aspects of investing in US real estate offers some guidelines on how such loans can be successfully negotiated.
Getting the right sort of loan
A good starting point for this overview of loan finance is the traditional distinction between the construction loan and the permanent loan, and the US institutions that tend to make one or the other. Commercial banks and savings and loan associations (ie building societies) tend to be more heavily involved in construction lending, whereas pension funds and insurance companies focus more on making permanent loans. And whereas construction loans are almost always at a floating rate based on a margin above prime or a similar benchmark rate, permanent loans are more commonly at a fixed rate. This is so despite the periods of inflation experienced in the late 1970s and early 1980s. Because inflation in the US is expected to remain at a relatively low level, permanent fixed-rate money is readily available and promises to continue to be the financing norm.
The non-recourse loan
One type of permanent loan that is still relatively new in the UK, although well-established in the US, is the non-recourse loan. In this case, the property alone stands as security for the debt so that, should the borrower default, the lender’s only recourse is against the property.
As a vehicle for financing construction the non-recourse loan is not usually available because the security is of little value until the building has been completed. Thereafter, however, most institutional lenders view a completed, leased-up property as a reliable source from which income will flow and, as a practical matter, the only source from which loan payments will be financed. What is more, few lenders expect a borrower to draw on his own funds in order to discharge a debt on a property investment that is not working out. And resort to bankruptcy in the US is a relatively easy matter.
Accordingly, while non-recourse lending is generally accepted, lenders invariably proceed with a high degree of caution, quite commonly requiring a “debt service ratio” of 120% or higher in order to secure their position. Let us assume, for example, that a property will produce $120 of net income per year (ie after management and operating costs, property taxes and insurance have all been paid). In this case a non-recourse loan can be made provided the combined annual payments of principal and interest do not exceed $100.
Costly commitment letters
The process by which a commercial real estate loan is negotiated is similar to the purchase and sale procedure itself. The transaction usually starts with a discussion followed by a “commitment letter” setting out the salient terms of the proposed agreement.
Commitment letters usually require the borrower to pay a substantial fee — anywhere between 1% and 3% of the amount to be borrowed — to the lender on signature. Recent cases have held that a borrower’s failure to proceed with a loan after the commitment letter has been signed may render the borrower liable for damages to the lender. From the borrower’s perspective it is, therefore, vital to provide that, should the borrower fail to proceed with the loan, forfeiture of the commitment fee is the lender’s only recourse.
Since loan transactions have become increasingly complex in recent years, preparation of the commitment letter can be a time-consuming and expensive process. As a result, it is becoming increasingly common for lenders initially to submit a preliminary letter, the so-called “request for proposal”. This is a simple letter prepared by the lender and signed by the borrower requesting that the lender provide a commitment letter and an undertaking to cover the cost of its preparation. In many instances, the “request for proposal”, signed by the borrower, must be accompanied by a cheque to cover the lender’s expenses.
Participating loans: beware the IRS
Over the past 10 years or so, participating loans have become increasingly attractive to US institutional lenders, whereas they have long been the norm in the UK. Most readers will therefore be familiar with the fundamentals of participating loans, but they may be unaware of some of the significant tax and accounting differences between the UK and the US that render certain aspects problematical.
For example, the Internal Revenue Service may regard a participating loan as a joint venture for tax purposes if it finds, among other things, that the extent of the lender’s control is inappropriate or that the lender’s return is too closely tied to the success of the underlying investment. Specifically, this risk becomes significant when the degree of participation exceeds 50%.
Participating loans may also raise basic questions of management and control. One such issue is who determines budgets and capital expenditures. Another is whether the borrower may exercise an unfettered right to determine whether, when and how a sale of refinance is to be made.
Yet a third situation raises the question: exactly what is the lender to participate in? “We’ve cheated him once and we’ll cheat him again, for why should the vicar take one part in ten?” is an old refrain which expresses a sentiment that is apposite in this context. Since this article is intended mainly for borrowers rather than lenders, we shall not go into the techniques by which wily borrowers can be circumscribed. Suffice it to say that these issues are only the tip of a large, dangerous iceberg.
Convertible mortgages
Relatively new on the US scene are convertible mortgages. Currently, these have a face rate of between 7.5% and 8% and give the lender the right to convert the loan into an equity interest, say 50%, after an initial period, say five years. Convertible mortgages have become quite popular with some Japanese lenders/investors, since such mortgages confer the freedom to act as genuine lenders without the concomitant responsibilities of management, while providing for an interest in the (presumed) profits.
Ideal as convertible mortgages may seem at first, such arrangements present significant tax problems for both parties. Not least of them is the fact that under the new tax laws, convertible debt cannot be “qualified non-recourse debt” that gives the borrower an additional “at risk” interest in the property. This limits the amount of depreciation which is a project can enjoy for tax purposes. This issue was examined in more detail in the first article in this series.
A checklist for borrowers
Regardless of the type of loan involved, the following issues and questions should be considered when negotiating loan contracts, and the earlier the better. The borrower should use this checklist as a basis for discussion from the very outset — including the very first meeting with the lender. While not providing any kind of guarantee, the checklist does give the borrower a leg up in resolving sticky issues in his favour:
- Grace periods
How long will the borrower have, after the due date for each monthly payment, before the loan is declared to be in default?
Surprisingly, many loans do not provide any grace period whatever, A closely related question is the amount of the late charge. It should not exceed 4%.
- Impound accounts
These require the prepayment — to the lender — of monthly instalments covering insurance and property tax payments, thereby effectively increasing the lender’s yield (since such sums never bear interest). Impound accounts should be negotiated out, unless conditioned upon default.
- Earthquake insurance
If the property is located in California, a lender may well require this coverage. While such insurance has recently become somewhat easier to obtain, it should not agreed to unless the premiums are, and remain, reasonable.
- Non-recourse provisions
If the loan is to be without recourse, this must be clearly set out in the commitment letter without prevarication or hedging.
- Due on sale/further encumbrance
Are sales of the property or further financings permitted without accelerating the indebtedness? This must be spelled out at the outset. If generally prohibited, any permitted exceptions (for example, the death of an individual principal) should be addressed.
- “Lock-in” provisions
Quite common with loans from life insurance companies, such clauses prevent prepayment by the debt, or permit it only with substantial premiums/penalties.
- Opinion letters/legal fees
Tucked away somewhere in all lenders’ commitment letters is a provision that states that an opinion of the borrower’s counsel is required as a condition precedent for funding the loan.
An opinion letter is far from being a casual observation reduced to writing. It is highly technical and it is an elaborate document confirming to the lender that the loan documents are legally valid and enforceable. Negotiating such documents is comparable to a square dance performed with micrometer exactitude. Also hidden in the fine-print will be another provision requiring the borrower to pay the lender’s costs and the legal fees in closing the transaction. Sometimes the financial implications of these provisions can be horrendous, especially for first-time investors.
By way of example, there was recently a $50m loan transaction in which the lender was represented by one of the more respected law firms in the US. This firm (which must remain nameless) raised an array of legal issues as abstruse as they were diverse, resulting in a legal bill to the borrower of $125,000. And this was only the lender’s legal fees! On top of this, of course, were the borrower’s legal fees, which had also escalated owing to the time spent fencing with the lender’s counsel.
Although this example is particularly egregious, the principle remains the same. So investors should do whatever they can, at an early stage in the transaction, to address this issue. One way is to limit the lender’s legal fees to a fixed dollar amount, or require that they be “reasonable”. This will at least give the borrower an opportunity to dispute the fees after the loan has closed.
For the British investor, negotiating an institutional loan in the US thus involves some unfamiliar problems in familiar garb. This renders it one of the trickier areas to traverse unassisted. It is, however, an area in which both borrowers and lenders have perfectly legitimate expectations. If properly addressed at an early stage, they can all be satisfied.
