The “Art” of Negotiating a Commercial Real Estate Mortgage Loan Term Sheet

When a borrower is seeking real estate financing, there is invariably timing pressure to solidify a mortgage loan term sheet (on occasion, in the form of a loan commitment or loan application), so that the next steps in the loan process (lender’s due diligence and loan document preparation) can be commenced quickly; with the ultimate goal being a prompt loan closing. The timing pressure is most often due to pending deadlines, such as a pending due diligence termination right or closing date under a contract of sale, or a loan maturity date under existing financing documents, or market or cost pressures, or concerns about rising interest rates or carrying costs of a project that needs funds for construction or other repositioning costs. Accordingly, many borrowers desire to avoid allowing the negotiation of the loan term sheet to get too protracted, and prefer to iron out the details (especially the legalese) in the definitive loan documents after the term sheet has been approved.

As experienced owners of commercial real estate, as well as their mortgage brokers and consultants (collectively, “CRE Professionals”), are well aware, the loan term sheet stage is when the borrower has the most leverage to negotiate acceptable loan terms. Once the term sheet is executed, and loan application fees are paid and good faith and expense deposits are made, the lender knows that the borrower is far less likely to walk on closing the loan because of unsatisfactory terms set forth in the definitive loan documents. Accordingly, when negotiating the loan term sheet, which will serve as the “blueprint” of the material terms of the proposed loan, there is a balancing act in determining which terms need to be negotiated upfront in the term sheet, in order to avoid the risk of being unable to satisfactorily negotiate them within the loan documents, and which terms the borrower can be reasonably comfortable leaving to negotiate in the loan documents in order to avoid unnecessary delays in completing the loan term sheet.

However, determining the “material terms of the loan” for a borrower to negotiate into the loan term sheet is an art, not a science. In particular, CRE Professionals are aware that they cannot attempt to cover every aspect (not even every material aspect) of a loan within the term sheet, as such an attempt would clearly derail the loan procurement process. Accordingly, the determination of what a borrower should negotiate into the term sheet involves an assessment and balancing of the risk of (i) failing to be able to negotiate material terms into the loan documents during the loan document review process, because such terms were not previously set forth in the term sheet, versus (ii) overly negotiating the term sheet and failing to move the transaction to closing in a timely fashion. In addition, in many cases, a strategic judgment will be made to purposely exclude a material term from the term sheet, with the intent to first raise the term during the loan document negotiation process. Another consideration is that certain modifications to the business terms may require lender’s underwriting approval, which could require significant lead-time to meet the closing date goal.

In almost every instance, certain terms will be included in the loan term sheet as they represent the threshold, central terms of the loan, such as identification of the lender, the borrowing entity, the loan amount, the interest rate, the repayment terms and maturity date, and the property serving as security for the loan. And many terms of the loan, subject to unusual deal specific issues, are generally recognized as not material enough to affect the overall business deal, and are typically excluded from the term sheet, such as events of default and remedies, and casualty and condemnation rights.

Over the years, in our real estate practice, we have found that there are several specific material terms of a commercial mortgage loan which are often excluded from the lender’s initial draft of the loan term sheet, and which borrowers regularly contemplate negotiating into the loan term sheet, as part of the “art” of negotiating the term sheet. These material terms include: (i) delineation of the matters guaranteed under a recourse carve-out guaranty; (ii) leasing rights, and (iii) rights to make indirect transfers of ownership interest in the borrower. A discussion of each of these material clauses is set forth below (note that, for the purposes of this discussion, we have not taken into account specific considerations applicable to construction or bridge-type financings).

Recourse Carve-Out Guarantees

In connection with non-recourse mortgage loans, it is very common for commercial mortgage loan term sheets to simply provide that the guarantor will deliver a “standard” or “customary” recourse carve-out guarantee (or words of similar import), without providing much detail as to exactly what will be guaranteed. However, what is “standard” or “customary” is certainly not clear, and in any event, the matters guaranteed under recourse carve-out guarantees have been constantly evolving and are far from consistent from lender to lender.

Undoubtedly, experienced CRE Professionals would expect the guarantor to have liability for losses due to fraud, intentional waste, hazardous materials and the misappropriation of rents following an Event of Default (i.e., a default continuing beyond the expiration of applicable notice and cure periods) under the recourse carve-out guaranty. In addition, the guarantor would be expected to be fully liable for the entire loan indebtedness if the borrower filed a voluntary bankruptcy petition, or voluntarily transferred or further mortgaged the property in violation of the loan documents.

However, over the years the number of matters that commercial mortgage lenders have sought to have subject to recourse liability has grown. Many lenders require guarantors to be personally liable for liens and real estate taxes, and for the payment of insurance. We have also seen lenders add liability for losses for matters that historically were non-recourse obligations of the borrowing entity, such as failure to allow the lender access to the property and the failure to deliver financial reports, when required. And many lenders provide for full-recourse liability in the event the borrower defends itself in response to the lender’s foreclosure of its mortgage or other enforcement action, or in the event of any violation of the provisions governing the indirect transfers of economic interest in the borrower.

These items are most typically negotiable. For example, liability for liens, taxes and insurance can be limited to the extent revenues are available from the mortgaged property to pay such costs. Liability for the borrower defending itself against a lender enforcement action can exclude defenses raised in good faith, and potentially such liability can be limited to losses incurred by the lender (rather than triggering full-recourse liability). Full recourse liability for violating the transfer provisions can be limited to actual, voluntary transfers of interests in violation of the loan documents (rather than violating less material provisions of the transfer restrictions, such as giving prior notice). With these provisions, the devil is definitely in the details, which makes it even more important to have the basic terms of the recourse carve-out guaranty clearly specified.

Given the need to be particularly sensitive to the potential personal liability of the guarantor, we almost always recommend to our borrowing clients that the details of the matters being guaranteed under the recourse carve-out guaranty be spelled out, up-front, in the loan term sheet.

Leasing Rights

Many commercial mortgage loan term sheets go into little detail with regard to the ability of the borrower to enter into and modify leases of the mortgaged property. Potentially worse from the borrower’s perspective, the term sheet will sometimes state that entering into leases is subject to conditions and restrictions to be further delineated in the loan documents.

Where revenue generated from the mortgaged property will be realized from commercial leases, such as retail, office or industrial leases, the ability of the borrower to freely enter into, modify and potentially terminate leases without the need to obtain the lender’s consent (or at least be certain that the lender must be reasonable and respond with little delay) is critical. However, the determination of what leasing rights are necessary to negotiate with the lender, and moreover, what rights should be raised at the term sheet stage, is very property and deal specific.

For a multi-family rental property, it may be enough to simply provide in the term sheet that the borrower may enter into residential leases and modifications of leases on market terms, for a term of not less than a specified time period, and with each lease being substantially in the form of lease pre-approved by the lender (and providing that such lease is subordinate to the mortgage). For other types of properties (e.g., office buildings, shopping centers, warehouses), lenders may be willing to allow the borrower to enter into and modify leases that are under a certain size (usually based on square footage), on market terms and not exceeding a specified term (among other conditions, such as substantially on the pre-approved form of lease). Above that size, the borrower can negotiate that the lender will not unreasonably withhold, delay or condition its consent; and can even negotiate for lender’s deemed approval, in the event the lender fails to respond to a request for approval within a stated time.

A related concept is the borrower’s need to obtain a non-disturbance agreement from the lender for the benefit of future tenants. This is most often required from tenants that take a large portion of the space at the mortgage property or are national or regionally recognized tenants. If this is relevant to the rental business at the mortgaged property, the borrower may be best served by raising it with the lender at the term sheet stage.

Indirect Transfer Rights

The lender’s underwriting process considers and relies on the experience, knowledge, credibility and financial wherewithal of a borrower’s principal owner(s); and, accordingly, in most cases the loan documents will prohibit a transfer of indirect ownership interest in the borrower. Most typically, transfers of indirect, non-controlling ownership interest constituting a small percentage of the ownership in the borrower, and estate planning type transfers, will be permitted by the lender so long as there is no change of control in the borrower. However, even these types of transfers can sometimes become an issue for lenders, in certain instances, so that having these rights set forth in the loan term sheet certainly helps to avoid the subsequent risk of not being able to negotiate these rights into the loan documents.

Where it is important to the borrower to have the ability to either make subsequent transfers of indirect ownership interest in the borrower to unrelated third-parties of greater than ten percent of the aggregate ownership interests in borrower, even if the subject transfers are of non-controlling ownership interest, it is even more important to raise this right at the loan term sheet stage. Depending upon the proposed percentage ownership interest to be transferred, the lender may balk at allowing these rights due to “know your customer” lender requirements or loan securitization restrictions.

Certainly, where the borrower has a potential plan to transfer more than 49% of the ownership interest in the borrower, the request for this transfer right should be raised at the outset during the negotiation of the loan term sheet. Very often, if the potential transferee is known at the loan term sheet stage, the potential transferee can be underwritten in advance of the closing and the subsequent transfer can be pre-approved. Once the loan documents have been drafted, and the required closing date is imminent, there may not be enough time to complete the underwriting process, putting aside the leverage the borrower has now giving up in connection with negotiating these transfer rights.

For more information on the topics discussed in this update, please contact any member of Tannenbaum Helpern’s Real Estate Law practice or your usual contact at the firm.

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02.23.2023  |  PUBLICATION: Note From The Real Estate Group  |  TOPICS: Real Estate  |  INDUSTRIES: Real Estate

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