OPM – Part II

Alec J. Pacella, CCIM

Last month, we had the first part of our “double period” and discussed various types of loan structures that can be utilized by a real estate investor. This month, we are going to roll into the second part of this discussion and highlight various key terms associated with loans.

There are two specific documents. The first is the mortgage, which pledges the real estate as collateral for the loan. Equally important is the promissory note (usually called the note), which is the document that contains the terms and conditions between the borrower and the lender. It memorializes the deal that both sides need to live with, so it’s important to understand some key components.

Loan amount

This is the amount of money the lender has provided. If funds are going to be held back from the full amount, the note will specify when and how the borrower will receive these additional funds.

Method of repayment

As discussed last month, there are all types of loans, including fully amortizing, partially amortizing, interest-only, participating, etc. This section of the note will detail exactly how, when and under what conditions the loan will be repaid.

Interest rate

The contract interest rate will be clearly stated in the note, along with a description of any future adjustments to this rate. For example, if the loan is tied to an index, this section will clearly state the index, the specific timing associated with future adjustments and any margin or spread that will be applied over the specified index.

Term

The note will include the initial date of the loan and the maturity date, or when the outstanding loan balance must be repaid to the lender. Some loans have a term that matches the amortization period. For example, loans originated by a pension fund will often have a 15-year term that matches up with a 15-year amortization period. However, most loans will have a term that is shorter than the amortization period. It may be amortized over 20 years but have a term, when the loan balance must be repaid, of five years.

Acceleration clause

This clause is always included in a note, as it gives the lender a strong position to force repayment. Under an acceleration clause, the lender has the right to declare the entire loan balance due in the event of default, which can be defined to include missing one or more mortgage payments, failing to keep the property maintained to building codes, failing to pay insurance premiums or property taxes, having a key loan metric such as debt service coverage ratio fall below a specified threshold, etc.

Because lenders have a direct interest in a property’s ability to generate income, they may use various mortgage covenants to specifically outline various controls. For example, a lender may have to approve leases that exceed a certain size threshold or consent to various repairs that exceed a certain dollar amount.

Most loans will have a grace period that allows the borrower the opportunity to cure some of these defaults.

Prepayment provisions

A lender may want to protect the yield received on a specific loan by specifying a time period which the loan cannot be prepaid, often called a lockout period. Or the loan may be allowed to be repaid with an associated pre-payment penalty. Certain loan products, most notably CMBS loans, will include a variation such as defeasance and yield maintenance, which allows the borrower to repay the loan according to a fairly sophisticated formula that again results in the yield being protected.

Due on sale

This clause will require full repayment of the loan upon the sale of the underlying real estate collateral.

Escrow/reserve accounts

A lender may establish various accounts that are used to withhold funds that are earmarked for specific events. The most common examples are escrow accounts for real estate taxes and property insurance premiums, as the lender will want to ensure that sufficient funds are available to pay these obligations when they become due. Reserve accounts go one step further and will withhold funds associated with a significant future expenditure. For example, if the roof on a large warehouse is anticipated to need replacement in a few years, the lender may require that the owner establish a reserve specifically to hold funds associated with this future replacement.

Property management & operation

Loan guarantees

Lenders may require additional security for the loan, beyond the value of the property, and a personal guarantee from the borrower is a common way to accomplish this. In the event a loan is personally guaranteed, the lender can require the borrower to pay any shortfall in the event of default or foreclosure. As a result, the security of the loan is beyond just the immediate real estate collateral and is extended to include other assets controlled by the borrower. A related concept is joint and several liability. If two or more borrowers are a party to a recourse loan, a joint and sev- eral loan guarantees the lender a right to recover the full amount of the deficiency from any of the borrowers, regardless of their ownership interest in the property.

Carveouts

Although not all loans contain guarantees/recourse, even non-resource loans will have some personal liability. These are commonly called carveouts and include full personal liability in certain events or circumstances. These circumstances include acts of fraud, misrepresentation, omission of facts or causing environmental damage to the property. Now that we have discussed the various forms a loan can take as well as the common terms and conditions they will contain, it’s time to get to some numbers. But that will have to wait until next month, when we head to the eighth and
final period of the school day.

Properties Magazine March 2023