Top 9 Things to Look out for Before Signing Loan Documents
Jan 13, 2017
Properly preparing yourself to sign a commercial mortgage agreement will minimize any frustration, unpleasant surprise, and potential financial loss that you may encounter throughout the life of the commercial loan. Unfavorable clauses and loan covenants included in a contract could have long-term consequences for an unsuspecting borrower.
Below you will find the top nine items in commercial loan documents that deserve your attention and detailed analysis during your loan signing.
Top 9 Things to Note Before Signing Your Commercial Loan Agreement:
(1) Loan Payment Agreement
The loan payment agreement of a commercial mortgage will often include provisions which offer protective features for both the commercial lender and the borrower. Understanding these provisions will help you identify your responsibilities and possibly the levels of risks you assume by accepting the commercial loan terms.
For instance, a loan provision to be aware of is whether your loan has a balloon payment feature or if the loan continues forth on an amortization schedule until the loan is paid off in full. If the loan does require you to make a balloon payment, more than likely you have a fixed rate loan and you will be required to pay off the remaining principal balance at the end of your fixed rate loan term. The advantage of taking a long-term, fixed-rate loan with a balloon payment is being able to lock in a rate that will offer consistent payment levels for the foreseeable future. Should rates rise, you will be able to maintain your lower monthly payments. However, being locked into a long-term, fixed rate also means that it could be cost prohibitive to take advantage of lower monthly payments should interest rates fall, due to the loan prepayment penalty. The good news is that commercial loans with balloon payments typically have a set period of months prior to the loan being due when there is no prepayment penalty. For example, a 10 year fixed loan could have a prepay period of 9.5 years and the remaining 6 months is open for a borrower to refinance without incurring a penalty. It’s important to know how long of a zero-prepay period you have and to plan your refinancing strategy accordingly.
Should circumstances arise which make it difficult to refinance your principal balance through a conventional lender, there are alternative commercial financing options, like those offered by Riverdale Funding, which can be of assistance.
(2) Cash Flow Requirements
Conventional commercial mortgage lenders will ask you to provide ongoing financial information about your commercial property, any entity holding title to the property, and personal financial information for the lifetime of the loan. The financial information required can be quarterly, semi-annual or annual submissions of tax returns, balance sheets, and income and expense statements. Maintaining a specific positive cash flow level or debt-to-cash-flow ratio may also be required as a condition of the loan.
Providing a conventional lender with required financial documents and reports is not likely a large enough reason for a borrower to not take a commercial loan. Nevertheless, having to consistently provide financial information to a lender can be time-consuming and feel intrusive. When you review your commitment letter and/or loan documents, you should note when you are required to provide this information to your lender.
(3) Loan Covenants
In addition to financial covenants, there may be several other types of covenants included in your commercial mortgage. These covenants can mandate operating activity, reporting and disclosure, preservation of debt seniority, investment expenditure, asset sale, cash payout and ownership. The thing to remember is that you need to review these mortgage contract elements carefully because if you violate one of these covenants, even inadvertently, you may be required to undertake a specified series of actions to maintain the relationship with your lender. If you negotiated or have been provided any specific terms or conditions, you should confirm that those agreements are in place before signing.
(4) Recourse / Non-Recourse Covenants
Obtaining a non-recourse commercial loan is something many borrowers wish to have in order to “protect” their personal assets in case of loan default. However, it would be good to remember that a non-recourse loan does not mean “no-recourse”. Non-recourse loans typically contain a “bad boy” clause, which gives the lender the right to legally pursue a borrower financially in the event the borrower willfully violates specific restrictions. The so-called “bad boy” acts include waste, fraud, misappropriation, bankruptcy, and incurring subordinate debt without permission. Because triggering one of these recourse guarantees could make you personally liable for a loan, you should review these areas of the mortgage agreement with great care. In certain instances, it can make sense to seek out a recourse loan. Recourse loans typically have lower interest rates and margin requirements. For example, if your commercial loan request has a very low loan-to-value ratio then the sale of the property, in the case of a default, would likely make the lender whole and not require the lender to pursue a borrower further.
(5) Adjusting Interest Rates
Adjusting interest rate commercial mortgages can be structured in a variety of ways that will ultimately effect how expensive your loan is. It’s therefore important to understand how often the rate will adjust and what the cap is per period. Often there are floor and ceiling rates which specify a maximum and minimum rate that your loan can adjust to. Take note, the minimum or “floor” rate is not always the same as the start rate. If this is the case then your interest rate, upon adjustment, can actually be lower than your start rate.
(6) Referencing Market Index
Of importance in the interest rate calculation is which index the contracted rate is tied to. In addition to prime or LIBOR, indexes can be based on interest averages from Treasury bills, Certificates of Deposit, the Cost of Funds, the Cost of Savings, and even swaps. The index average that’s used to formulate the interest rate can be calculated across varying lengths of time. Some interest rates are based on a 6 month averaged LIBOR rate while others could be averaged annually. Researching the historical performance of the index associated with your loan is critical in accurately predicting the lifetime interest costs of your loan.
(7) Prepayment Penalties
Most conventional lenders will add a prepayment penalty to their commercial loans. This penalty is incurred if the borrower decides to pay more than the agreed upon rate within a certain timeframe after agreeing to the loan. These penalties can take various forms such as step-downs, lock-out periods, yield maintenance, or defeasance. A commercial borrower needs to gain clarity around their goals in financing the property and any associated timelines prior to agreeing to the prepayment specifications. If your property finance plan involves selling your commercial property or accelerating your debt repayment, then you need to make sure that your loan has a prepayment penalty that is in line with your plans.
(8) Review Closing Loan Documents vs. Letter of Interest
Upon receiving your loan documents, you need to make sure that the major terms are the same as those you received in any previous documents you were given, such as the final commitment letter and the initial letter of interest. If there is a discrepancy, then it should be resolved with your lender before you sign.
(9) Loan Funding Conditions
Funding conditions are last-minute, check-the-box items the borrower must satisfy before the lender will release the loan. These conditions can include confirmation of certain funds deposited with the lender, notarized letters of obligation from foreign partners, or verification of insurance. Not completing these can stall or delay your loan closing so make sure to take note and complete them quickly.
Preparing to Sign a Commercial Mortgage Contract
Signing a commercial mortgage contract can feel like the final step in a very long process that includes finding the right property, obtaining inspections, running calculations, and securing commercial financing. However, it is precisely at this moment that a commercial borrower should slow down and prepare for a detailed review of the documents in front of them. The terms of your mortgage contract can have a significant impact on the overall profitability of your investment. By preparing yourself and focusing on the right elements you will get the best terms and subsequent experience with your commercial mortgage.