The 3 Most Confusing CRE Lending Concepts for Borrowers

September 17, 2020 • Author: Howard Taylor
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Acquiring a commercial mortgage loan can be a complicated process. Even veteran developers with decades in the industry can sometimes struggle navigating the market. This is especially true when the market is unsteady, like during an election year, a pandemic or amidst national-scale social unrest, as we currently have.

Don’t agonize over the borrowing process. The Griffin Group team is here to make each transaction seamless, and straightforward. We will shed light on even the most confusing aspects of commercial real estate financing. Let’s start with some of the commonly misunderstood concepts you may encounter at the initiation of a loan request.

1. Equity options for the capital stack

All lenders, be they regulated or unregulated, are always cognizant of sponsor equity. The distinction between debt and equity is clear enough, but what about the different types of equity? There are multiple instruments of equity, the most popular of which include Straight, Preferred and Joint Venture.

Straight Equity offers shared ownership of an asset in exchange for an ownership interest — generally, in proportion to the cash or cash equivalent investment, or perhaps a contribution of expertise.

Preferred Equity is similar, but usually entitles investors to receive returns on an LP vs GP basis. Another difference with Preferred Equity (Pref), is an incentive given to the GP as an additional benefit, should the project perform in accordance with pre-set hurdles by virtue of promotes. Pref is mostly measured on a look-back from day-1 as it relates to an agreed IRR and multiple.

Joint Venture (JV) Equity is when two principals forge an agreement where each bring either capital, experience, or accreted land equity to the table. A key difference between JV and Pref is that there’s generally no priority of payment on proceeds. Any profit from a capital event or cash flow distribution is often paid pari passu, or “equal footing”, depending on the investment percentages in the agreement.

2. A “Term Sheet” is an outline, not a commitment letter

One of the biggest frustrations a borrow may experience, is receiving a final offer that looks different from the initial term sheet. To alleviate this frustration or feeling of being “re-traded”, is to understand the purpose of this document and its function.

A term sheet is not a commitment letter. It is always subject to things like appraisal, environmental and due diligence on metrics given by the sponsor to the lender. It is an important document that outlines the proposed terms and conditions which the lender is willing to provide. However, the sponsor needs to be well aware that they must provide the documentation requested, and that it meets or exceeds the expectations of the lender. These documents need to be submitted on a timely basis.

Term Sheets are customarily drafted after a lender has received enough information, so that the transaction can then move forward to a full underwriting. Thus, term sheets are not lender commitments and they are not binding, but are indicative terms. Typically, further documentation is requested in the Term Sheet, so the underwriters can do a full analysis on the borrower and the project.

It is during this analysis of documents like personal financial statements (documented with brokerage statements, bank statements, etc.), the appraisal, environmental, market analysis, comp-rents and sales, etc., that new discoveries may be made, which could alter the original offer. Once all parties agree, that is when a more formal meeting of the minds takes place.

3. Skin in the game

For regulated lenders, the OCC recommends that lenders establish hard equity guidelines, and conduct an analysis of the borrower’s equity to be documented in the credit file. It is recommended that a borrower’s equity contributions should be significant. For unregulated lenders, the parameters for keeping borrower’s “skin in the game” are very boutique per lender.

The reason why equity is so important, is because it ensures that a borrower has a stake in the project. It is in the best interest of the lender to ensure the borrower continues to have economic interest in the project’s success, regardless of whether the loan is non-recourse or recourse.

The greatest misconception about this part of the lending process, is which types of equity and equity sources are considered acceptable. It can be confusing because an equity type that is considered acceptable to one lender, might be considered unacceptable to another. Pace Bonds, Grants, Historic Tax Credits, TIF’s, Facade Easement Funds, Grants, CDD’s, etc. — the status of these being counted as equity are subject to any given lender’s policy.

The Griffin Group has been battle tested for 40 years. Our team has successfully endured Prime at 21%, inverted yield curves, 9/11, the 2008 Recession, as well as Sarz, Ebola, H1N1 — and now COVID-19. Because of our experience, The Griffin Group is qualified to help you through these uncertainties, and provide you with the funding you need.