Last week, we started a list of loan terms that regularly seem to be left out of Loan Term Sheets prepared by lenders despite those term sheets using up an entire tree for what is included. If you didn’t see that posting and you are compelled to start at the beginning of our Ruminations, click HERE to start at the beginning. Today, we continue and then conclude our list. Don’t confuse “conclude our list” with “conclude the complete list,” because we know the limits of our ability and experience. A further caveat would be – every deal has its own factors to consider, but most loan term sheets attempt to fit all shape pegs into a round hole.
So, here we go with the rest of our list of “missing” terms in the common Loan Term Sheet:
Cash Management Accounts. If a borrower can avoid a “clearing account” (essentially, a “lock box”), it should. For those unfamiliar with how those work, the lender “owns” an account at the bank you choose and all rent checks go to that account. Your bank agrees, with the lender, to “sweep” all money out of that account every night and put the swept funds in your own account. That is, it will do that sweep until the lender notifies the bank to sweep the money into the lender’s regular bank account (at whatever bank the lender uses). That allows the lender to interrupt the cash flowing to the borrower when the lender thinks a “Trigger Event” has occurred. A Trigger Event could be the borrower’s default or it could be that the rental income, though exceeding the debt service payments, doesn’t exceed it by enough. It could also be when a key tenant has left the property. In fact, it could be anything the loan documents say it is, including receipt of a report of alien abduction signed by two adults. Though the last example is unlikely, it does illustrate that if the Loan Term Sheet calls for a cash management account, it should state what the Trigger Events would be.
An alternative to establishing a clearing account (where the business negotiation leads to such a result) is to have a standby arrangement wherein, upon the occurrence of a Trigger Event, the clearing account (lockbox) would be activated and the lender, holding signed letters from its borrower, would mail a notice to each tenant directing each of them to start sending the rent to the lockbox’s mailing address.
If there is to be a clearing account, the borrower can expect the Loan Term Sheet to say that once the “sweep” directs money to the lender, the lender, even after it takes the loan payment out of those funds, only plans to release enough money to its borrower for its borrower to pay taxes, pay insurance premiums, maintain the property, and the like. That means the lender intends to hold the excess cash flow (the borrower’s personal income) as additional collateral until such time as the Trigger Event is done and over for six months, a year, two years, whatever. The conditions for the end of the sweep into the lender’s account needs to be spelled out in the Loan Term Sheet and needs to be negotiated. All of the foregoing might be obvious if the terms of the cash management account are set forth in the Loan Term Sheet. What might not be obvious is something you won’t find on the initial proposal – a cap on how much the lender will retain – call it “trap.” At some point, the lender should be releasing the excess trapped money to its borrower (assuming there is no continuing event of default). After all, that’s the borrower’s “pay check” and incentive to vigorously operate the mortgaged property.
Financial Accounting. Almost always, loan term sheets require financial reports to be prepared using GAAP (Generally Accepted Accounting Principles). We won’t return to thoughts posted by Ruminations long ago about the eventual, expected replacement of GAAP by IFRS (International Financial Reporting Standards). Research that yourself by using our blog’s built-in search engine. For today’s purpose, we’ll answer the question – “What’s the problem with using GAAP?” Well, for one, GAAP relies on accrual accounting and many, many (perhaps most) borrowers use cash method accounting. Ask your accountant and she’ll tell you more. So, borrowers should insist that any accounting method generally in use in the United States for the preparation of financial data be an acceptable method for the borrower’s reports.
While we’re at it, not many borrowers pay for or obtain audited financial statements. If your accountant isn’t sending out “confirmation” notices to a bunch of tenants and suppliers, you aren’t getting audited statements. Oh, yes, we almost forgot, to get your accountant to prepare audited statements, you’re going to pay extra, often a lot extra.
Property Management. It isn’t unusual or improper for a number of items in a lender’s Loan Term Sheet (in essence) to call for the borrower’s use of a property management company acceptable to the lender. Make sure it agrees that your current property management (even if self-management) is acceptable and also that any regional or national property management company is presumptively acceptable.
Insurance Requirements. As long as Ruminations postings can be (and have been), today’s would find its place in the Guinness Book of Records if we were to fully explore what Loan Term Sheets don’t say, but should say, about insurance requirements. So, even though what a borrower will see on the lender’s standard “form” and believe to be “standard” and “reasonable,” the borrower will be wrong. Borrowers should not fail to get the Loan Term Sheet’s insurance requirements reviewed by a knowledgeable insurance professional. This isn’t an “if time permits” matter. Bet your bottom dollar that the people who negotiate the actual loan documents (on each “side”) won’t fully appreciate the ins and outs of “insurance,” and the lender’s side will keep pointing to what the Loan Term Sheet (Loan Application, Loan Commitment or Loan Whatever) the borrower signed says as “proof” that the insurance provisions are not further negotiable. Aside from calling for coverages for earthquake, alien invasion, or floods in areas where such insurance is unusual and wasteful (other than to the premium collecting insurance carriers), Loan Term Sheets seem to always call for “and such other coverages as we might think of later at our whim.” The “think of later” may be appropriate for long-term loans given that “things really do change over time,” but the words that translate into “at our whim” should be tempered. So, borrowers should try to make its particular lender abide by typical lending practices in the geographic area for properties of the same type and scale.
While we’re at it, here’s a reminder. Thirty day notice of cancellation of an insurance policy isn’t very available when the cancellation is for non-payment of the premium. Borrowers should expect to hear that from their insurance consultants if they’ve gotten the proposed insurance requirements to their consultant.
Lender’s Costs. Often, you wouldn’t know that lenders should have some costs of their own. Increasingly, lenders ask borrowers to pay all or part of the costs a lender will incur to sell the loan or package the loan with others or split the loan with one or more of its colleagues. The same goes with passing along “loan servicer fees” if there is a loan servicer. If passing along any of those costs is what the Loan Term Sheet says and it’s fine with the borrower, so be it. But if the loan sheet speaks somewhat generally and obliquely about the borrower paying some of the lender’s post-transaction costs, borrowers should pipe up and say, “Not those we didn’t cause you to incur.” We’ve given you some examples.
Approval of Leases. A lender has a reasonable concern that its borrower will impair the collateral security by signing burdensome or below market leases with tenants. After all, if the lender gets “stuck” taking over the property and tries to resell it, crummy leases yield crummy recoveries. On the other hand, if the lender knows “best” to whom to lease space and under what terms, then let the lender own its own properties or protect its borrower from all the consequences of those leases not “working out.” There needs to be a balance. If the Loan Term Sheet doesn’t set a size (square footage, length of term, dollar amount) threshold for lender approval of a particular lease, then it should. Also, as to leases that won’t need lender review and approval before signing, borrowers should get their lender’s “sign-off” on a form lease that, in form and substance, would be deemed acceptable. Commercially reasonable deviations from that form also should be deemed acceptable. Lease forms of national or regional tenants for space below the “threshold” should be deemed acceptable. Lease modifications that don’t materially, adversely affect the lender should be acceptable. Lenders who don’t respond to lease approval requests within 10 days should be deemed to have accepted the submitted lease. Tenants don’t hang around forever.
A related issue is when and whether a borrower can terminate a tenant lease. As long as an agreed-upon debt service coverage ratio is being met, a borrower should be able to agree, with a tenant, to terminate an extant lease. Even if that debt service coverage ratio would not be met, borrowers should be able to agree to terminate a lease if the termination is contingent on the effectiveness of a replacement lease with that same tenant or a new tenant and the ratio would thereby be met. Borrowers need to terminate leases of non-paying tenants or of those where it would be commercially reasonable to terminate the lease based on some other event of default. Loan Term Sheets also tend to leave that out as an exception to the provision that says borrowers can’t terminate leases without the lender’s consent.
Tenant Protection. Here’s a challenge to Ruminations readers. Find a lender’s form of Loan Term Sheet that promises to give SNDAs to tenants. Let’s face it, the real estate market is like a three-legged stool. It legs are the lender, the property owner, and the tenant. Without any one of those, the stool won’t stand. A Loan Term Sheet should require the lender to negotiate in good faith and give a commercially reasonable SNDA to tenants occupying more than, say, 2.500 or 3,500 square feet of space, if not to all tenants. Lenders should be required to give an SNDA on the form required by existing leases if those leases call for a particular form (or don’t offer or make the loan – you liked the tenant; now like the lease). The same goes with estoppel certificates – lenders need to negotiate reasonably and to honor the estoppel certificate provisions of existing leases. Tenants under leases that, by their own terms, are subordinate to the lien of the mortgage should not be required to sign a subordination agreement. All SNDAs should include the lender’s agreement to apply insurance proceeds and eminent domain awards in accordance with the lease.
Use of Insurance Proceeds. It’s peculiar, but pretty common at the same time, that Loan Term Sheets don’t tell the prospective borrower that the lender will want to be able to keep all insurance proceeds if the lender feels like it. What’s peculiar about that is that the economics of a property don’t necessarily change just because there has been a fire of any size. After all, the value of the property is almost always preserved by the availability of insurance proceeds for restoration. And, the rental income would be unchanged by the availability of what, in the vernacular, is commonly called “rent insurance.” So, if a borrower can supplement the insurance proceeds with additional funds sufficient to restore the property, and if it can be shown that the rental income after the restoration will be sufficient to service the loan, why should the lender pay the loan back to itself? Readers will discern that the loan documents can include reasonable criteria which, if met, would give the borrower the right to apply the proceeds to repairs and restoration. Those might vary depending on the type of mortgaged property involved or the diversity of tenancies, but lenders, when pressed, will concede the point. Often, the agreement will have three features. The first is that losses of less than a certain amount (based on the value of the property) will be paid directly to the borrower. The second is that losses that don’t meet criteria designed to predict a situation where the loan can be serviced even though the property was damaged will result in the lender taking the proceeds to pay down the loan. The last is that where the proceeds can be used for restoration, those proceeds would be held by the lender and then paid out as the repairs progress (with the borrower adding its own funds if the insurance proceeds won’t “cut it”).
Between last week’s posting and this one, we’ve presented a pretty long list of items that you can expect to be missing from a lender’s proposed Loan Term Sheet. Don’t confuse a long list with a complete list and don’t ever fancy the thought that because we’ve used half a dictionary’s worth of words, our treatment is comprehensive. Ruminations is written for “thinkers” like you. So, while you can safely stand on our musings to gain a “little” height in your loan negotiations, don’t fool yourself into thinking you can see Russia. All barbs and zingers are being graciously accepted as comments. Just find the word “comment” or some form of that word near the title to today’s blog posting and click it to open the comment window. Then, type your thoughts.