Since 1978, R. Kymn Harp, a real estate attorney at Robbins, Salomon and Patt Ltd., has represented borrowers and lenders in commercial real estate transactions. Throughout the process of negotiating the sale contract, all parties must keep their eye on what the Buyer’s lender will reasonably require as a condition to finance the purchase. This may not be what the parties want to focus on, but if this aspect of the transaction is ignored, the deal may not close at all.
Sellers and their agents often express the attitude that the Buyer’s financing is the Buyer’s problem, not theirs. Perhaps, but facilitating Buyer’s financing should certainly be of interest to Sellers. How many sale transactions will close if the Buyer cannot get financing?
This is not to suggest that Sellers should intrude upon the relationship between the Buyer and its lender, or become actively involved in obtaining the Buyer’s financing. It does mean, however, that the Seller should understand what information concerning the property the Buyer will need to produce to its lender to obtain financing, and that the Seller should be prepared to fully cooperate with the Buyer in all reasonable respects to produce that information.
Basic Lending Criteria
Lenders actively involved in making loans secured by commercial real estate typically have the same or similar documentation requirements. Unless these requirements can be satisfied, the loan will not be funded. If the loan is not funded, the sale transaction will not likely close.
For Lenders, the object, always, is to establish two basic lending criteria:
1. The ability of the borrower to repay the loan; and
2. The ability of the lender to recover the full amount of the loan, including outstanding principal, accrued and unpaid interest, and all reasonable costs of collection, in the event the borrower fails to repay the loan.
In nearly every loan of every type, these two lending criteria form the basis of the lender’s willingness to make the loan. Virtually all documentation in the loan closing process points to satisfying these two criteria. There are other legal requirements and regulations requiring lender compliance, but these two basic lending criteria represent, for the lender, what the loan closing process seeks to establish. They are also a primary focus of bank regulators, such as the FDIC in verifying that the lender is following safe and sound lending practices.
Great ability to repay may allow for the borrower to obtain a greater loan to value ratio on a particular loan, or may allow a borrower to obtain a tighter debt coverage ratio for a particular project, and may even result in a lower interest rate on a loan because of a lower perceived risk of default, but it will seldom result in lender accepting inadequate collateral resulting in a loan which is even partially unsecured. This may not be always true, but it is usually true.
Few lenders engaged in commercial real estate lending are interested in making loans without collateral sufficient to assure repayment of the entire loan, including outstanding principal, accrued and unpaid interest, and all reasonable costs of collection, even where the borrower’s independent ability to repay is substantial. As we have seen time and again, changes in economic conditions, whether occurring from ordinary economic cycles, changes in technology, natural disasters, divorce, death, and even terrorist attack or war, can change the “ability” of a borrower to pay. Prudent lending practices require adequate security for any loan of substance.
Documenting the Loan
There is no magic to documenting a commercial real estate loan. There are issues to resolve and documents to draft, but all can be managed efficiently and effectively if all parties to the transaction recognize the legitimate needs of the lender and plan the transaction and the contract requirements with a view towards satisfying those needs within the framework of the sale transaction.
While the credit decision to issue a loan commitment focuses primarily on the ability of the borrower to repay the loan; the loan closing process focuses primarily on verification and documentation of the second stated criteria: confirmation that the collateral is sufficient to assure repayment of the loan, including all principal, accrued and unpaid interest, late fees, attorneys fees and other costs of collection, in the event the borrower fails to voluntarily repay the loan.
With this in mind, most commercial real estate lenders approach commercial real estate closings by viewing themselves as potential “backup buyers”. They are always testing their collateral position against the possibility that the Buyer/Borrower will default, with the lender being forced to foreclose and become the owner of the property. Their documentation requirements are designed to place the lender, after foreclosure, in as good a position as they would require at closing if they were a sophisticated direct buyer of the property; with the expectation that the lender may need to sell the property to a future sophisticated buyer to recover repayment of their loan.
Top 10 Lender Deliveries
In documenting a commercial real estate loan, the parties must recognize that virtually all commercial real estate lenders will require, among other things, delivery of the following “property documents“:
- Operating Statements for the past 3 years reflecting income and expenses of operations, including cost and timing of scheduled capital improvements.
- Certified copies of all Leases.
- A Certified Rent Roll as of the date of the Purchase Contract, and again as of a date within 2 or 3 days prior to closing.
- Estoppel Certificates signed by each tenant (or, typically, tenants representing 90% of the leased GLA in the project) dated within 15 days prior to closing;
- Subordination, Non-Disturbance and Attornment (“SNDA”) Agreements signed by each tenant;
- An ALTA lender’s title insurance policy with required endorsements, including, among others, an ALTA 3.1 Zoning Endorsement (modified to include parking) [or if a multi-tenant property, an ALTA 3.0 Zoning Endorsement (modified to include parking), ALTA Endorsement No. 4 (Contiguity Endorsement insuring the mortgaged property constitutes a single parcel with no gaps or gores), and ALTA Access Endorsement No. 17 (insuring that the mortgaged property has access to public streets and ways for vehicular and pedestrian traffic);
- Copies of all documents of record which are to remain as encumbrances following closing, including all easements, restrictions, party-wall agreements and other similar items;
- A current Plat of Survey prepared in accordance with 2011 Minimum Standard Detail Requirements for ALTA/ACSM Land Title Surveys certified to the lender, Buyer and the title insurer, including items 1 through 4, 6(a), 7(a), 7(b)(1), 8 through 10(a), 11(a) and 14 from the Surveyor’s “Optional Survey Responsibilities and Specifications” referred to as “Table A”;
- A satisfactory Environmental Site Evaluation Report (Phase I Audit) and, if appropriate under the circumstances, a Phase 2 Audit, to demonstrate the property is not burdened with any recognized environmental defect; and
- A Property Condition Assessment Report [ASTM Standard 2018] to evaluate the structural integrity of improvements and general physical condition of the property.
To be sure, there will be other requirements and deliveries the Buyer will be expected to satisfy as a condition to obtaining funding of the purchase money loan, but the items listed above are virtually universal. If the parties do not draft the purchase contract to accommodate timely delivery of these items to the lender, the chances of closing the transaction are greatly reduced.
Planning for Closing Costs
The closing process for commercial real estate transactions can be expensive. In addition to drafting the Purchase Contract to accommodate the documentary requirements of the Buyer’s lender, the Buyer and his advisors need to consider and adequately plan for the high cost of bringing a commercial real estate transaction from contract to closing.
If competent Buyer’s counsel and competent lender’s counsel work together, each understanding what is required to be done to get the transaction closed, the cost of closing can be kept to a minimum, though it will undoubtedly remain substantial. It is not unusual for closing costs for a commercial real estate transaction with even typical closing issues to run thousands of dollars. Buyers must understand this and be prepared to accept it as a cost of doing business.
Sophisticated Buyers understand the costs involved in documenting and closing a commercial real estate transaction and factor them into the overall cost of the transaction, just as they do costs such as the agreed-upon purchase price, real estate brokerage commissions, loan brokerage fees, loan commitment fees and the like.
Closing costs can constitute significant transaction expenses and must be factored into the Buyer’s business decision-making process in determining whether to proceed with a commercial real estate transaction. They are inescapable expenditures that add to the Buyer’s cost of acquiring commercial real estate. They must be taken into account to determine the “true purchase price” to be paid by the Buyer to acquire any given project and to accurately calculate the anticipated yield on investment.
Some closing costs may be shifted to the Seller through custom or effective contract negotiation, but many will unavoidably fall on the Buyer. These can easily total tens of thousands of dollars in an even moderately sized commercial real estate transaction in the $1,000,000 to $5,000,000 price range.
Costs often overlooked, but ever-present, include title insurance with required lender endorsements, an ALTA Survey, environmental site assessment(s), a Site Improvements Inspection Report, and, somewhat surprisingly, Buyers attorney’s fees.
For reasons that escape me, inexperienced Buyers of commercial real estate, and even some experienced Buyers, nearly always underestimate attorneys fees required in any given transaction. This is not because they are unpredictable, since the combined fees a Buyer must pay to its own attorney and to the Lender’s attorney typically aggregate around 1% of the Purchase Price.
This 1% figure consistently rings true, even though attorney’s fees in commercial real estate transactions are typically billed hourly, rather than on a percentage basis. In the hundreds of commercial real estate transactions I have been involved in, I have found that hourly-based attorneys’ fees payable by the Buyer/Borrower at closing typically range between .80% and 1.10% of the Purchase price, depending on the complexity of the transaction involved. For commercial real estate transactions with a purchase price smaller than $1,000,000, the percentage is typically higher. When the purchase price is higher than about $8,000,000, the percentage is typically smaller. The percentage usually breaks down as follows: Lender’s attorney’s fees (which the Borrower must typically pay) average between .25% and .30% of the loan amount. Fees for the Buyer’s attorney usually average between .65% and .85% of the Purchase Price.
Perhaps it stems from wishful thinking associated with the customarily low attorneys’ fees charged by attorneys handling residential real estate closings. In reality, the level of sophistication and the amount of specialized work required to fully investigate and document a transaction for a Buyer of commercial real estate makes comparisons with residential real estate transactions inappropriate. Sophisticated commercial real estate investors understand this. Less sophisticated commercial real estate buyers must learn how to properly budget this cost.
Concluding negotiations for the sale/purchase of a substantial commercial real estate project is a thrilling experience but, until the transaction closes, it is only ink on paper. To get to closing, the contract must anticipate the documentation the Buyer will be required to deliver to its lender to obtain purchase money financing. The Buyer must also be aware of the substantial costs to be incurred in preparing for closing so that the Buyer may reasonably plan its cash requirements for closing. With a clear understanding of what is required, and advanced planning to satisfy those requirements, the likelihood of successfully closing will be greatly enhanced.