Typical Structure of a Commercial Mortgage Term Sheet
Commercial mortgages are loans against real estate either used for a business purpose, or as an investment. They also apply to housing properties of at least 5 units (in the US). While most home buyers and residential real estate investors are at least familiar with the structure of a residential mortgage, commercial mortgages are more structured. While these commercial loans often contain customizations, there is an industry standard for many terms you’ll see on most commercial mortgages in the US.
Principal Loan Amount
The total gross amount of the loan is usually quoted as a dollar value (like $5,000,000), but is often constrained by particular underwriting variables as well, namely DSCR and LTV (or LTC in a construction scenario). So a lender may offer you the lesser of $7,000,000 or 70% of the property’s appraised value. In that case, if the appraisal comes back at less than $10,000,000, the loan’s principal will be lower.
Collateral is something of value that the loan is being pledged against. In the most common scenario, that is the first lien against the property.
Interest in other properties can also be included as collateral for a loan, in which case the loan is said to be “cross-collateralized”. In some mezz debt scenarios, the owner’s equity interests in the property may be used as collateral.
How long you get to keep the money until the lender asks for the remainder that you owe back. Important distinction here vs residential mortgages is that this is usually a different length of time than how long it takes to fully pay off the loan. See “Amortization” below.
The Rate is the “pricing” of the loan, and may be either fixed or floating (quoted as a spread over an index). Pretty self explanatory, but you can follow the underlined link to explore the factors behind your commercial mortgage rate.
This is the amount of time that it would take to pay down the full loan principal balance. The amortization period is often longer than the loan term, meaning that you’ll need to pay back the loan while it still holds a principal balance, which can be accomplished by selling the property or refinancing to a new loan.
Learn more about Amortization.
Many lenders will penalize early return of their loan principal, particularly on fixed rate loans. The simplest prepayment penalties can be stated as a percentage of the loan balance, often descending from a high penalty (5%) in the first year, and descending to a 1% penalty in a later year. But other loans will assess a prepayment penalty according to “Yield Maintenance”, as in making sure the lender receives enough of a penalty to cover the current value of interest they would have received. For securitized loans, the process for paying back the loan early is called Defeasance, and it is one of the most expensive ways to get out of a loan before maturity.
Recourse determines if the borrower is personally responsible to pay back a loan balance upon default, after the collateral is collected.
Learn more about Recourse.
The fees associated with originating a commercial mortgage loan come in a few varieties, and are typically deducted from the total proceeds of the loan at closing, rather than paid out of pocket by the borrower. However, a typical bank loan will require the borrower putting down a good faith deposit upon executing the term sheet, kicking off the due diligence process.
Fees on the loan can include an origination fee and underwriting fee that would cover the lender’s own costs, and then third party fees associated with due diligence and closing such as an appraisal fee, title insurance, environmental approvals, credit checks, and legal costs. A lender will typically provide guidance on third party fees at the term sheet stage, but these are subject to change based on actual costs during due diligence.
Other Common Items
The cash management provisions laid out in your loan terms will determine if and when the lender may receive the right to collect rent payments directly from the tenants at a property, rather than allowing the sponsor (borrower) to collect rent payments themselves. This may happen because the borrower is at risk of defaulting on the loan, or for some other reason related to the lender’s risk of receiving loan payments due.
Property Insurance Requirements
Lenders will always require some level of insurance on the property/collateral, whether that be standard liability insurance, or protection in the case of natural disasters (particularly in flood/earthquake zones) or environmental hazards. In the case of a construction loan, there may also be stipulations about builder’s risk.
Financial Reporting Requirements
Some level of financial reporting requirement on loans is common, particularly for more heavily regulated financial institutions. On a securitized loan, the borrowing entity may be required to provide financial reports audited by an approved third party at some regular interval. The goal for the lender (or loan servicer to be more exact) is to monitor the asset’s financial health, and not to be caught off guard by any risk of default.
A commercial loan may require the borrowing entity to “store up” funds according to a pre-determined amount, in order to cover potential capital expenses. These capital reserves may be required up front upon loan origination, or as a monthly contribution up to a certain amount, or some other way. Required Reserves are more common for plans that include heavy capital expenditures.
Finally, a term sheet may include custom requirements or provisions tailored to the unique real estate at hand. At the end of the day, a lender wants to address all the potential risks at hand for a given loan. A commercial mortgage is not a standardized financial product and is often a large capital commitment, so the lender will look to add structure to keep their investment safe.
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