Obtaining a commercial loan is often a complex endeavor….
Obtaining a commercial loan involves a myriad of documents and terms that need to be reviewed and negotiated. Given the complexity involved in these transactions, it is important that borrowers and lenders appropriately address the key terms of the transactions at the outset and incorporate those terms, with the appropriate amount of detail in the commitment letter.
All too often, the borrower and lender enter into a commitment letter that either does not address enough of the key terms regarding the transaction, or does not provide enough detail surrounding the key terms addressed in the commitment letter. This lack of clarity can often lead to surprises further into the transaction in the form of increased costs, delayed timelines, or deal breaking terms.
Several common issues that are often not adequately addressed in the commitment letter are prepayment penalties, opinions of counsel, environmental diligence, and surveys, each of which is discussed in further detail below.
Most term loans are going to involve some form of fee in the event the borrower wishes to pay any portion of the principal of the loan in advance of its due date, often referred to as a prepayment penalty or prepayment fee. This could mean paying additional principal every month above what is required according to the amortization schedule or paying the entire loan off prior to the scheduled maturity date. Borrowers should be sure to have a discussion with their lender at the loan commitment stage in order to determine what restrictions the lender is intending to impose regarding borrower’s ability to prepay.
While the borrower should not necessarily expect that they will be able to convince their lender to remove the prepayment penalty, as prepayment penalties are often reasonable or in some cases necessary for the lender to be able to justify the structure of the loan they are offering, the borrower should be sure to discuss whether the lender will allow any exceptions to the application of the prepayment penalty. These exceptions could include, a fixed amount of additional principal that the borrower can pay in any given year without incurring a prepayment penalty, an exception for any prepayment that is not made in connection with a refinance of the loan with another lender. The borrower may also want to discuss whether the prepayment penalty will apply to an involuntary prepayment, such as where the lender accelerates the balance of the loan due to the occurrence of an event of default.
Opinions of Counsel
Depending on the type of loan being offered, the type of collateral being secured, the complexity organizational structure of the borrower and guarantors, or a variety of other factors, the lender may require that the borrower provide the lender with an opinion letter provided by the borrower’s attorney covering certain issues deemed significant by the lender in making the loan.
These opinions may include, (i) an opinion regarding the enforceability of the loan documents, (ii) an opinion that the borrower has the authority to enter into the loan and that all of the applicable requirements have been met under the borrower’s organization documents, (iii) an opinion regarding the perfection of the lender’s security interest in the collateral for the loan, (iv) an opinion regarding the zoning of real property that is being used as collateral for the loan, (v) an opinion that the borrower generally complies with all applicable laws, or (vi) any combination of any of the foregoing. These opinions can often be very expensive and it is critical that the borrower understand at the loan commitment stage what opinions the lender is going to require.
All too often the commitment letter will only indicate that the lender is requiring an “opinion of counsel” and won’t be specific as to what particular opinions the lender is requiring to be provided in the opinion of counsel. If the borrower believes that the lender is only requiring an opinion regarding the organizational requirements of borrower as opposed to an opinion regarding the perfection of lender’s security interest in certain personal property being used as collateral, the borrower could be in for a rude awakening as to the cost of the opinion of counsel, after having already spent a significant amount of time and money on other diligence for the loan.
Environmental diligence is often an unavoidable part of a commercial real estate loan. The question that borrowers need to focus on; however, is how much environmental diligence will the lender require. Typically, if the lender is going to require environmental diligence, it will usually take the form of (i) a transaction screen, (ii) a Phase I environmental assessment, (iii) an extended Phase I environmental assessment, or (iv) a Phase II environmental assessment. The range of cost and time across the aforementioned forms of environmental diligence can be significant. For example, a transaction screen is based on a standard questionnaire of 20 questions and 16 observable site conditions along with limited records searches and interview requirements. Alternatively, a Phase I environmental assessment addresses the following five general assessment areas: (i) historical site information, (ii) a site visit, (iii) personal interviews, (iv) database radius searches, and (v) local agency inquiries.
In addition to concerns regarding cost and timeline, borrowers often need to be cognizant of whether they will have the right to undertake the type of environmental diligence required by their lender. Most purchase contracts restrict certain types of environmental diligence, mostly relating to soil testing, as these types of tests could result in mandated reporting of negative information to the Maryland Department of the Environment. If, for example, a lender is going to require a Phase II as a condition to making a real estate acquisition loan, the borrower will need to confirm that they have the right to perform a Phase II in their purchase and sale agreement with the seller, prior to signing the commitment letter.
If the loan is going to be secured by real estate, the lender will likely ask for the borrower to provide a survey of the property. The borrower should be aware that there are several types of surveys, each with a different level of cost and time associated with them. Often times, the lender is not specific in the commitment letter as to what particularly type of survey they are requiring, or how current the survey needs to be. Sometimes a borrower can convince a lender that no survey is required or that an existing survey is adequate, provided there have been no substantive changes to the property.
Alternatively, if the lender is requiring a current ALTA survey, not only could the survey itself cost a significant amount of money, but the timeline for preparation of the ALTA survey often ranges from a few weeks to even a few months, depending on the complexity involved in the property being surveyed. Depending on how quickly the borrower needs to close on the loan, having a clear understanding of the exact survey requirements at the commitment stage is paramount for the borrower. Surveys can also be problematic on smaller loans, because the cost of the survey, by percentage of the loan, can be cost-prohibitive to obtaining the loan.
While the aforementioned list of issues is by no means exhaustive, the key take away is that borrowers and lenders need to ensure they have a sufficiently detailed understanding of the key components of the loan and the diligence required to issue the loan as early as possible in the transaction. This comprehensive and unified understanding of the loan and those items necessary to get to closing will provide a strong foundation for the transaction, limit surprises, and provide for a smooth and efficient closing of the transaction.
Tom Simmons is a partner with Liff, Walsh & Simmons, where he counsels clients in all aspects of real estate, business, and finance transactions. This article is for informational purposes and is not intended to be and should not be taken as legal advice.