REAL ESTATE “FINANCE” OUTLINE
Rider Spring 2005
I. INTRODUCTION
Scope of Course: This is primarily a contracts course in commercial real estate
Relevant Law: UCC Article 9, Environmental Law, Usury Law, Bankruptcy Law
Players in the Business: lenders, borrowers, and others
Lenders:
Banks and Thrifts
Life Insurance Companies
Finance: invest premiums collected and in one way is to finance commercial real estate.
Manage Retirement Accts: manage pensions and retirement accounts and a part of their portfolio is invested into commercial real estate.
University of Endowments: Harvard Endowment is a large commercial RE lending entity
Real Estate Investment Trust (REIT): publicly owned companies that lend to commercial RE developers, method to allow ordinary persons to invest in commercial real estate.
Investment Banking Houses:
Local and National: Chase, UBS
Securitization
Borrowers:
Entrepreneurs seeking investment property
Businesses: (i.e. fiber optical cable companies purchasing easements and land for towers)
Federal Government
Consumer Credit:
Other Players: Title Surveyors, Lawyers, Mortgage Brokers
Equity Market v. Debt Market
Equity Investment Market: NYSE, Stocks, RE, Partnerships
Part owner and return depends on the success of the enterprise
Historically Equity Markets have given a higher return for a higher risk
Debt Market: Financing Acquisitions
Bond: form of debt document evidencing a certain return (rent on money); obligation
Lower Return for less risk—more certainty
If the enterprise craters, the bondholders and creditors (lenders) get the money first. Equity holders get money only after the bondholders and creditors are first paid reflecting the higher risk
Why do lenders lend and borrowers borrow?
Lenders Lend because:
Certainty:
Investors who have capital and want greater certainty enter the debt market (Investors lend b/c less risk)
Certainty varies and the interest rates vary according to certainty: senior and junior creditors
Baseline Interest Rate: rate the Federal Government pays on its debt—lowest interest rate b/c least risky.
Diversity
Investors want both equity and bonds
Ex. Insurance Companies are required by law to diversify their investments
Types of Loans
Real Estate Lending has historically returned approx 1.75% more than an equivalent corporate lending investment
Asset Based Lending: Real Estate Lending is secured lending—secured by the real estate. The underlying real estate provides greater security
Less liquid investment so return is higher on investment
Corporate Bonds: Typical corporate bonds are unsecured
Participating Loans: an effort to blend equity and debt
Lender will participate in the profits
Inflation protection
Promissory Note provides interest and perhaps a % of the revenue or profits
Borrowers borrow b/c
Acquire capital for business
Leverage: Enhance your return (see example)
Works both ways increases your return or increases your losses
Leverage
Invest $2m
Invest $2m
Borrow $8m
$10m for 5 shopping center
Income $240K (12%)
Expense$80K(4%)
Income $160K (8%)
Income $1.2m
Expense $400K
Expense $560K (interest)
Income $240K (12%)
Sell Shopping Ctrs @ $3m each
$3m sale
$2m cost
$1m profit
$15m sale
$8m debt
$2m invest
$5m profit
Real Estate Lending Cycle:
I. Permanent Commitment: first thing to do is to arrange the last (long-term) loan; contract (agmt to loan) to make a loan for a certain sum in the future with conditions attached
Institutions: usually national companies with stable long-term cash inflows
Insurance companies, REITs—have long term cash available for investment (lenders are matching cash outflows with their cash inflows)
Terminology:
Forward Commitment: Commitment forward in time
Takeout
Standby: permanent lender will standby until conditions are met then loan the money
II. Construction Loan Commitment: once permanent loan is obtained, developer/borrower must find a short-term loan that will finance the construction. This is a big business for local commercial banks b/c by the nature of the bank’s business it is a short-term lender (Bank borrows short-term and wants to lend short-term).
Interim Construction Loan: another term for a construction loan
Construction is typically known as a “standing loan”—no principal paid until permanent loan is funded
Short-Term lenders are generally local whereas permanent lenders may be more national or global.
Matching short term funds available for invest with short term investments
Local bank has the ability to monitor the progress of construction
III. Construction Loan Closing: point in time where money exchanges;
Opening: paradox term used in NY for the same event—money begins flowing, a construction loan closing or construction loan opening
IV. Permanent Loan Closing: if conditions are met, then the permanent loan will be funded and the RE owner will pay the lender monthly. The loan will pay off the construction loan, the permanent loan in effect is refinancing the construction.
Refinance: borrow money from one lender to pay off another lender
Long-term loan: p&i payments will be the same every month—stable payments
Variations of the RE Cycle:
Buyer of existing building: buyer will go directly to the permanent financier (insurance company, REIT, ect.) and then close the permanent loan
Build to Sell: developer will obtain a construction loan commitment and close it;
Typically, an entity has already agreed that upon completion of construction it will buy the building
Acquisition and Development Financing: developer will obtain a construction loan commitment and close the construction loan. Developer has a purchaser(s), selling developed parcels of land. The construction lender will look to the purchase contract to ensure he will get repaid
Terminology:
Commitment: contract to make the loan and borrow the money; part of the web of arrangements part of the RE cycle
Debt Instrument: evidence of the loan, a K where the borrower promises to pay (i.e. promissory note, bond). Prepayment, liability issues are dealt with in this instrument
Security: having an asset to secure the payment of the loan (i.e. Mortgage or Deed of Trust); is the legal tool used to enforce borrower non-performance
Collateral: the asset at risk
Guarantor
Principal: amount of the loan outstanding
Amortization: way the loan principal is repaid, describes the program for repayment
Maturity: point at which the borrower must pay the loan; Statute of Frauds requires maturity
Interest: rent paid for the use of money; compensation paid to the lender for allowing the borrower to use his money
Fixed Rate Interest:
Floating Rate: based on formula whereby rate fluctuates according to prevailing rates
Usury Laws: religious based laws that limit amount of interest charged
Default: breach of loan (i.e. failure to make loan payments)
Foreclosure: occurs after default
II. A: LOAN COMMITMENT
· Loan Commitment: a K today for a future loan
· A. Overview of the Loan Process:
o 1. Find Lender/Borrower:
o 2. Loan commitment: DNA of loan transaction
o 3. Lender due diligence—satisfaction of conditions
o 4. Closing
o 5. Lawyer Roles—anticipate needs of client, quarterback and coordinate
§ Lawyer will often know more about the process than the client
§ Client must understand his existing contractual obligations
§ Lawyer does most of the negotiation often up to 80% of the deal—the lawyer is engaged in the deal
· B. Legal Requirements of Loan Commitment
o Statute of Frauds: TX Bus Commercial Code 26.01 and 26.02 General SOF—agmt not enforceable unless signed in writing, includes “contract for the sale of RE” or “lease for term of more than 1yr.” this has been interpreted by courts as anything that provides for transfer of interest in RE so this includes a lien—necessary to comply with SOF for loan commitment
§ Loan Commitment must comply with SOF
§ In the commercial RE world the loan commitments are completely negotiable—no standard industry forms
§ SOF only applies to RE finance loans if there is a creation of a RE interest
§ TX Bus Cd 26.02: only applies to loans over $50K, and certain institutions, including banks, credit unions, and mortgage companies. Does NOT include traditional commercial RE lenders like insurance companies.
· Limited scope to certain institutions but broad in that it applies to all loans including any transactions involving RE
· Statute passed as a result of the 1980 RE crisis, where borrowers claimed that the lender made an oral promise to extend the loan upon original maturity.
§ SOF requires Parties, Amount, Maturity, and Description of Collateral
§ (1) Parties: Borrower and Lender
· SOF requires that the commitment name the borrower and lender
· The DNA of the deal may require other parties like a guarantor:
o Guarantor: Borrower may require more security and thus other parties
§ (2) Amount: Law requires a definite amount
· Not necessary for a fixed amount
· If no fixed amount, the formula to obtain the amount must be definite and attainable with certainty
o Judge must be able to calculate
§ (3) Maturity: certain enough to be made definite
· Law requires that the timing and payments be certain—may be fixed or formula
· Ex. Loan pmt calculated over 25 yrs with a certain interest rate for certain term.
· Most RE professionals want a constant amortization so that cash outflows are predictable
§ (4) Description of Collateral: law requires a description of collateral to comport with SOF.
· (1) Must have a description of RE—must have a description of a unique piece of dirt.
o (a) Lot and Block:
§ Platt is a regulatory document which creates a short hand land description that is recorded publicly in lots and blocks
§ The commitment may refer to the platt and comply with the SOF
o (b) Metes and Bounds: SOF allows a metes and bounds description, but as a lawyer this will raise a red flag because the land may not have been through the proper regulatory process for development (i.e. land may not have proper utilities) Legal Lot Doctrine
o (c) Reference to a Document containing either a metes and bounds description or a lot and block description complies with the SOF
· (2) Must have a definite description of any other collateral
o Fixtures and Appurtenances: Further describing property even beyond the legal minimum requirements:
§ What comes with the description of the dirt? Fixtures and appurtenances come with the dirt
§ Fixture—some addition to RE that can not be removed from the RE without damaging the RE or when removed from the RE no longer useful by itself. Fixtures obviously include the building
§ Issues: what is a fixture? Does the equipment bolted to the building come with the building?
§ As a lawyer for the lender you want the collateral to be operational and functioning so must think beyond just the dirt to the fixtures and appurtenances.
o Escalators, furniture, A/C, elevator must be put in the description of the collateral to ensure that they are included as collateral and to avoid disputes as to what constitutes a “fixture”
o Mineral rights and water rights are considered appurtenances
· C. Process of Negotiation
o Application: must read both the “application” and the loan commitment and apply contract law—offer, acceptance, consideration and counter offer
§ A client that has submitted a loan application which could be an offer and the client may by signing have committed himself to a contractual agreement putting the client “up a creek”
§ Alternatively, the lender might send a letter the says “Loan Commitment” constituting an offer.
§ Counter Offer: conditional acceptance letter; “subject to your acceptance”
o Deposits: customary for the would be borrower to deposit an amount money
§ Deposit could be consideration binding the parties to a contract
· D. Important Issues for inclusion into the loan commitment:
o Rate of Interest: not as a matter of SOF, but as a matter of K interpretation must be in the commitment.
§ Fixed Rate
· Fixed Rate can be determined in the future: i.e. parties may agree that the interest rate on the loan will be 2% higher than the 10 year treasury rate on the day we close. K rate is not fixed until the day of closing.
§ Floating Rate:
§ As a matter of K interpretation, the interest rate must be definite enough to determine the contracted rate
§ Rate of interest is NOT implied must contract for interest
o Prepayment / Implied Terms
§ Implied Terms: matters of presumed intent that the court will enforce unless the parties agree otherwise.
§ Prepayment:
· Default Rule (Minority ROL): TX adopts the minority position that the law presumes that installment notes are NOT pre-payable unless agreed otherwise
o TX has the rule of perfect time and tender
o Effect: If you can not prepay then you may not refinance the deal
o Negotiate at the commitment stage
· Majority Rule: the law presumes that installment may be prepaid thus refinance is possible
o The lender that wants to prohibit prepayment must contract otherwise
o Liability / Recourse / Exculpation
§ Issue: if I do not repay the loan what happens? What else is at risk beyond the underlying asset? What recourse does the lender have against the borrower beyond the underlying assets securing the payment?
§
at economic substance and not form to determine the implications
o Bilateral Contracts: promise for a promise
§ Bilateral Conditional Contract: bilateral contract which depends upon the occurrence of some condition or contingency
· Ex. Seller offers to sell car for $5,000 and buyer accepts offer if his mechanic gives the car a clean bill of health. The K is binding upon offer and acceptance, and the only way out is if the mechanic finds the car is in poor condition
§ No separate consideration is necessary: exchange of promises are enough, and the K can only be terminated upon the occurrence (or failure of occurrence) of some future event.
· Blurring the line of consideration with Broad Discretionary Conditions: The K may be an option (with no consideration) rather than a bilateral K if the condition subsequent is too subjective (i.e. my wife must approve of the loan)
· Issue: At what point does the condition become so ambiguous/discretionary that it is illusory?
· Attorney Approval Clauses are very similar to a termination right without considerationà outer boundary issue
§ Contract Conditions:
· Typical loan commitment contracts contain several conditions, some express, others implied, that must be met or waived for the loan to close
· Conditions postpone contract performance
· Issue: whether the prescribed conditions leave so many terms open that no enforceable contract has been formed
· When a party relies on a condition to renege the contract, the court will examine the motives of the party relying on the condition – parties are bound to act in good faith
o TX: Implied obligation to use diligence in seeing that the condition is met; this implied covenant prevents the arrangement from becoming a unilateral option contract
§ Rhodessa
o Drafting Issues: *Borrower’s Attorney: Try to draft the contract so that it is a unilateral/option contract and the borrower is a discretionary party (include a termination right OR specify that independent consideration is the sole remedy upon default).
§ Hypo: Bank has given your client a “Loan Commitment” but no consideration was given for the loan commitment.
· Unilateral Offer; an option with no consideration is not binding
§ Hypo: Lender issues a “Loan Commitment” to your client. Your client believes interest rates may decline. Therefore as the attorney counter with a unilateral contract or a bilateral contract with a termination right or a liquidated damages clause.
· Client wants a termination right so that if interest rates fall he can terminate the contract. Must give the lender independent consideration for this termination right.
· Client wants to be the discretionary party.
o Contract Relationship
§ Parties have no fiduciary or special relationship
§ No duty of good faith and fair dealing
§ Duty of reasonableness in judging the satisfaction of conditions
§ Duty of good faith to see that the conditions are met
· F. Breaches and Remedies
o There must first be a breach: (El Paso Hotel Case)
§ The non-exercise of an option is not a breach
§ The failure of a condition is not a breach
o Woodbridge Place Apartments Case
§ Facts: Borrower wanted to refinance an apartment complex. Borrower entered (signed) into a loan commitment with a new lender; the commitment included a standby deposit provision to be paid by the borrower and forfeited if the borrower did not meet the loan conditions. The condition provided that the new lender would fund the loan only if 93% of the apts are rented. At the time of the loan, borrower did not have 93% rented.
§ Holding: The standby deposit is really a liquidated damages provision in the event the borrower breaches the contract. The court holds that the borrower did not breach the contract, simply the conditions for funding the loan agreement were not met.
· The borrower failed to satisfy the condition, and thus no breach and remedy analysis
· Contract did not provide for what happened if the condition was not met and therefore the court gave back the commitment fee.
· Common to see that the lender will pay its cost back then give the difference b/w the fee and the costs back to the borrower.
o Borrower Breach / Lender Remedies:
§ Specific Performance: Does the lender have specific performance as a remedy if borrower breaches? NO. No specific performance—lender can not force the borrower to take the loan
§ Damages: either (1) contractual damages (i.e. liquidated damages provision) or (2) difference in interest rates
· If no contract clause follow common law (i.e. No Liquidated Damages Clause)
· Damages remedy is the amount of interest that the lender would have received less the interest the lender can receive today
o Lender Breach / Borrower Remedies
§ Specific Performance: an equitable remedy that requires a finding that damages are not adequate/available and also a finding of uniqueness (some unique aspect of the transaction that can not be obtained without enforcing the current contract)
§ Damages: lender does not fund the loan and the borrower is jilted.
· i.e. borrower contracted to borrower at a certain rate and now rates have gone up.
· Lender must pay the difference in the interest rate that the borrower would have borrowed at and the current higher rate that the borrower is now forced to borrow at
