For nearly 30 years, I have represented borrowers and lenders in commercial real estate transactions. During this time it has become apparent that many Buyers do not have a clear understanding of what is required to document a commercial real estate loan. Unless the basics are understood, the likelihood of success in closing a commercial real estate transaction is greatly reduced.

Throughout the process of negotiating the sale contract, all parties must keep their eye on what the Buyer’s lender will reasonably require as a condition to financing the purchase. This may not be what the parties want to focus on, but if this aspect of the transaction is ignored, the deal may not close at all.

Sellers and their agents often express the attitude that the Buyer’s financing is the Buyer’s problem, not theirs. Perhaps, but facilitating Buyer’s financing should certainly be of interest to Sellers. How many sale transactions will close if the Buyer cannot get financing?

This is not to suggest that Sellers should intrude upon the relationship between the Buyer and its lender, or become actively involved in obtaining Buyer’s financing. It does mean, however, that the Seller should understand what information concerning the property the Buyer will need to produce to its lender to obtain financing, and that Seller should be prepared to fully cooperate with the Buyer in all reasonable respects to produce that information.

Basic Lending Criteria

Lenders actively involved in making loans secured by commercial real estate typically have the same or similar documentation requirements. Unless these requirements can be satisfied, the loan will not be funded. If the loan is not funded, the sale transaction will not likely close.

For Lenders, the object, always, is to establish two basic lending criteria:

1. The ability of the borrower to repay the loan ; and

2. The ability of the lender to recover the full amount of the loan, including outstanding principal, accrued and unpaid interest, and all reasonable costs of collection, in the event the borrower fails to repay the loan.

In nearly every loan of every type, these two lending criteria form the basis of the lender’s willingness to make the loan. Virtually all documentation in the loan closing process points to satisfying these two criteria. There are other legal requirements and regulations requiring lender compliance, but these two basic lending criteria represent, for the lender, what the loan closing process seeks to establish. They are also a primary focus of bank regulators, such as the FDIC, in verifying that the lender is following safe and sound lending practices.

Few lenders engaged in commercial real estate lending are interested in making loans without collateral sufficient to assure repayment of the entire loan, including outstanding principal, accrued and unpaid interest, and all reasonable costs of collection, even where the borrower’s independent ability to repay is substantial. As we have seen time and again, changes in economic conditions, whether occurring from ordinary economic cycles, changes in technology, natural disasters, divorce, death, and even terrorist attack or war, can change the “ability” of a borrower to pay. Prudent lending practices require adequate security for any loan of substance.

Documenting The Loan

There is no magic to documenting a commercial real estate loan. There are issues to resolve and documents to draft, but all can be managed efficiently and effectively if all parties to the transaction recognize the legitimate needs of the lender and plan the transaction and the contract requirements with a view toward satisfying those needs within the framework of the sale transaction.

While the credit decision to issue a loan commitment focuses primarily on the ability of the borrower to repay the loan; the loan closing process focuses primarily on verification and documentation of the second stated criteria: confirmation that the collateral is sufficient to assure repayment of the loan, including all principal, accrued and unpaid interest, late fees, attorneys fees and other costs of collection, in the event the borrower fails to voluntarily repay the loan.

With this in mind, most commercial real estate lenders approach commercial real estate closings by viewing themselves as potential “back-up buyers”. They are always testing their collateral position against the possibility that the Buyer/Borrower will default, with the lender being forced to foreclose and become the owner of the property. Their documentation requirements are designed to place the lender, after foreclosure, in as good a position as they would require at closing if they were a sophisticated direct buyer of the property; with the expectation that the lender may need to sell the property to a future sophisticated buyer to recover repayment of their loan.

Top 10 Lender Deliveries

In documenting a commercial real estate loan, the parties must recognize that virtually all commercial real estate lenders will require, among other things, delivery of the following “property documents”:

1. Operating Statements for the past 3 years reflecting income and expenses of operations, including cost and timing of scheduled capital improvements;

2. Certified copies of all Leases;

3. A Certified Rent Roll as of the date of the Purchase Contract, and again as of a date within 2 or 3 days prior to closing;

4. Estoppel Certificates signed by each tenant (or, typically, tenants representing 90% of the leased GLA in the project) dated within 15 days prior to closing;

5. Subordination, Non-Disturbance and Attornment (“SNDA”) Agreements signed by each tenant;

6. An ALTA lender’s title insurance policy with required endorsements, including, among others, an ALTA 3.1 Zoning Endorsement (modified to include parking), ALTA Endorsement No. 4 (Contiguity Endorsement insuring the mortgaged property constitutes a single parcel with no gaps or gores), and an Access Endorsement (insuring that the mortgaged property has access to public streets and ways for vehicular and pedestrian traffic);

7. Copies of all documents of record which are to remain as encumbrances following closing, including all easements, restrictions, party wall agreements and other similar items;

8. A current Plat of Survey prepared in accordance with 2005 Minimum Standard Detail for ALTA/ACSM Land Title Surveys, certified to the lender, Buyer and the title insurer, including items 1 through 4, 6, 7(a), 7(b)(1), 8 through 11(a) and 14 from the Surveyor’s “Optional Survey Responsibilities and Specifications” referred to as “Table A”;

9. A satisfactory Environmental Site Evaluation Report (Phase I Audit) and, if appropriate under the circumstances, a Phase 2 Audit, to demonstrate the property is not burdened with any recognized environmental defect; and

10. A Site Improvements Inspection Report to evaluate the structural integrity of improvements.

To be sure, there will be other requirements and deliveries the Buyer will be expected to satisfy as a condition to obtaining funding of the purchase money loan, but the items listed above are virtually universal. If the parties do not draft the purchase contract to accommodate timely delivery of these items to lender, the chances of closing the transaction are greatly reduced.

Planning for Closing Costs

The closing process for commercial real estate transactions can be expensive. In addition to drafting the Purchase Contract to accommodate the documentary requirements of the Buyer’s lender, the Buyer and his advisors need to consider and adequately plan for the high cost of bringing a commercial real estate transaction from contract to closing.

If competent Buyer’s counsel and competent lender’s counsel work together, each understanding what is required to be done to get the transaction closed, the cost of closing can be kept to a minimum, though it will undoubtedly remain substantial. It is not unusual for closing costs for a commercial real estate transaction with even typical closing issues to run thousands of dollars. Buyers must understand this and be prepared to accept it as a cost of doing business.

Sophisticated Buyers understand the costs involved in documenting and closing a commercial real estate transaction and factor them into the overall cost of the transaction, just as they do costs such as the agreed upon purchase price, real estate brokerage commissions, loan brokerage fees, loan commitment fees and the like.

Closing costs can constitute significant transaction expenses and must be factored into the Buyer’s business decision-making process in determining whether to proceed with a commercial real estate transaction. They are inescapable expenditures that add to Buyer’s cost of acquiring commercial real estate. They must be taken into account to determine the “true purchase price” to be paid by the Buyer to acquire any given project and to accurately calculate the anticipated yield on investment.

Some closing costs may be shifted to the Seller through custom or effective contract negotiation, but many will unavoidably fall on the Buyer. These can easily total tens of thousands of dollars in an even moderately sized commercial real estate transaction in the $1,000,000 to $5,000,000 price range.

Costs often overlooked, but ever present, include title insurance with required lender endorsements, an ALTA Survey, environmental audit(s), a Site Improvements Inspection Report and, somewhat surprisingly, Buyers attorney’s fees.

For reasons that escape me, inexperienced Buyers of commercial real estate, and even some experienced Buyers, nearly always underestimate attorneys fees required in any given transaction. This is not because they are unpredictable, since the combined fees a Buyer must pay to its own attorney and to the Lender’s attorney typically aggregate around 1% of the Purchase Price . Perhaps it stems from wishful thinking associated with the customarily low attorneys fees charged by attorneys handling residential real estate closings. In reality, the level of sophistication and the amount of specialized work required to fully investigate and document a transaction for a Buyer of commercial real estate makes comparisons with residential real estate transactions inappropriate. Sophisticated commercial real estate investors understand this. Less sophisticated commercial real estate buyers must learn how to properly budget this cost.

Conclusion

Concluding negotiations for the sale/purchase of a substantial commercial real estate project is a thrilling experience but, until the transaction closes, it is only ink on paper. To get to closing, the contract must anticipate the documentation the Buyer will be required to deliver to its lender to obtain purchase money financing. The Buyer must also be aware of the substantial costs to be incurred in preparing for closing so that Buyer may reasonably plan its cash requirements for closing. With a clear understanding of what is required, and advanced planning to satisfy those requirements, the likelihood of successfully closing will be greatly enhanced.

R. Kymn Harp is a seasoned attorney based in Chicago, Illinois with 30 years experience representing commercial real estate investors, lenders and developers. He is a frequent speaker at continuing education seminars, and is a widely published author on commercial and industrial real estate topics including due diligence, entitlements, commercial real estate financing, and Brownfield development and financing.

R. Kymn Harp can be contacted at:

Robbins, Salomon & Patt, Ltd
25 E. Washington Street Suite 100
Chicago, IL 60602
Dir. Ph: 312-456-0378
Email: rkharp@rsplaw.com

For more information go to: http://www.realestate-law.com

Are you seeking to raise capital for your real estate transaction? Try one of our Real Estate Private Placements

Due Diligence Checklists – For Commercial Real Estate Transactions
By R. Kymn Harp

Planning to purchase or finance Commercial or Industrial Real Estate? Shopping Center? Office Building? Restaurant/Banquet property? Parking Lot? Storefront? Gas Station? Manufacturing facility? Warehouse? Logistics Terminal? Medical Building? Nursing Home? Hotel/Motel? Pharmacy? Bank facility? Sports and Entertainment Arena? Other?

A KEY to investing in commercial real estate is performing an adequate Due Diligence Investigation to assure you know all material facts to make a wise investment decision and to calculate your expected investment yield.

The following checklists are designed to help you conduct a focused and meaningful Due Diligence Investigation.

Basic Due Diligence Concepts:

Commercial Real Estate transactions are NOT similar to large home purchases.

Caveat Emptor: Let the Buyer beware.

Consumer protection laws applicable to home purchases seldom apply to commercial real estate transactions. The rule that a Buyer must examine, judge, and test for himself, applies to the purchase of commercial real estate.

Due Diligence: “Such a measure of prudence, activity, or assiduity, as is proper to be expected from, and ordinarily exercised by, a reasonable and prudent [person] under the particular circumstances; not measured by any absolute standard, but depending upon the relative facts of the special case.” Black’s Law Dictionary; West Publishing Company.

Contractual representations and warranties are NOT a substitute for Due Diligence.

Breach of representations and warranties = Litigation, time and money.

WHAT DILIGENCE IS DUE?

The scope, intensity and focus of any due diligence investigation of commercial or industrial real estate depends upon the objectives of the party for whom the investigation is conducted. These objectives may vary depending upon whether the investigation is conducted for the benefit of (i) a Strategic Buyer (or long-term lessee); (ii) a Financial Buyer; (iii) a Developer; or (iv) a Lender.

If you are a Seller, understand that to close the transaction your Buyer (and its Lender) must address all issues material to its objective – some of which require information only you, as Owner, can adequately provide.

GENERAL OBJECTIVES:

(i) A “Strategic Buyer” (or long-term lessee) is acquiring the property for its own use and must verify that the property is suitable for that intended use.

(ii) A “Financial Buyer” is acquiring the property for the expected return on investment generated by the property’s income stream, and must determine the amount, velocity and durability of the revenue stream. A sophisticated Financial Buyer will likely calculate its yield based upon discounted cash-flows rather than the must less precise capitalization rate (“cap rate”), and will need adequate financial information to do so.

(iii) A “Developer” is seeking to add value by changing the character or use of the property – usually with a short-term to intermediate-term exit strategy to dispose of the property; although, a Developer might plan to hold the property long term as Financial Buyer after development or redevelopment. The Developer must focus on whether the planned change is character or use can be accomplished in a cost-effective manner. A developer conducting due diligence will focus on issues involving market demand, access, use and finances.

(iv) A “Lender” is seeking to establish two basic lending criteria:

1. “Ability to Repay” – The ability of the property to generate sufficient revenue to repay the loan on a timely basis; and

2. “Sufficiency of Collateral” – The objective disposal value of the collateral in the event of a loan default, to assure adequate funds to repay the loan, carrying costs and costs of collection in the event forced collection becomes necessary.

The amount of diligent inquiry due to be expended (i.e. “Due Diligence”) to investigate any particular commercial or industrial real estate project is the amount of inquiry required to answer each of the following questions to the extent relevant to the objectives of the party conducting the investigation:

I. THE PROPERTY:

1. Exactly what PROPERTY does Purchaser believe it is acquiring?

(a) Land?

(b) Building?

(c) Fixtures?

(d) Other Improvements?

(e) Other Rights?

(f) The entire fee title interest including all air rights and subterranean rights?

(g) All development rights?

2. What is Purchaser’s planned use of the Property?

3. Does the physical condition of the Property permit use as planned?

(a) Commercially adequate access to public streets and ways?

(b) Sufficient parking?

(c) Structural condition of improvements?

(d) Environmental contamination?

(i) Innocent Purchaser defense vs. exemption from liability

(ii) All Appropriate Inquiry

4. Is there any legal restriction to Purchaser’s use of the Property as planned?

(a) Zoning?

(b) Private land use controls?

(c) Americans with Disabilities Act?

(d) Availability of licenses?

(i) Liquor license?

(ii) Entertainment license?

(iii) Outdoor dining license?

(iv) Drive through windows permitted?

(e) Other impediments?

5. How much does Purchaser expect to pay for the property?

6. Is there any condition on or within the Property that is likely to increase Purchaser’s effective cost to acquire or use the Property?

(a) Property owner’s assessments?

(b) Real estate tax in line with value?

(c) Special Assessment?

(d) Required user fees for necessary amenities?

(i) Drainage?

(ii) Access?

(iii) Parking?

(iv) Other?

7. Any encroachments onto the Property, or from the Property onto other lands?

8. Are there any encumbrances on the Property that will not be cleared at Closing?

(a) Easements?

(b) Covenants Running with the Land?

(c) Liens or other financial servitudes?

(d) Leases?

9. Leases?

(a) Security Deposits?

(b) Options to Extend Term?

(c) Options to Purchase?

(d) Rights of First Refusal?

(e) Rights of First Offer?

(f) Maintenance Obligations?

(g) Duty on Landlord to provide utilities?

(h) Real estate tax or CAM escrows?

(i) Delinquent rent?

(j) Pre-Paid rent?

(k) Tenant mix/use controls?

(l) Tenant exclusives?

(m) Tenant parking requirements?

(n) Automatic subordination of Lease to future mortgages?

(o) Other material Lease terms?

10. New Construction?

(a) Availability of construction permits?

(b) Utilities?

(c) NPDES (National Pollutant Discharge Elimination System) Permit?

(i) Phase 2 effective March 2003 – Permit required if earth is disturbed on one acre or more of land.

(ii) If applicable, Storm Water Pollution Prevention Plan (SWPPP) is required.

II. THE SELLER:

1. Who is the Seller?

(a) Individual?

(b) Trust?

(c) Partnership?

(d) Corporation?

(e) Limited Liability Company?

(f) Other legally existing entity?

2. If other than natural person, does Seller validly exist and is Seller in good standing?

3. Does the Seller own the Property?

4. Does Seller have authority to convey the Property?

(a) Board of Director Approvals?

(b) Shareholder or Member approval?

(c) Other consents?

(d) If foreign individual or entity, are any special requirements applicable?

(i) Qualification to do business in jurisdiction of Property?

(ii) Federal Tax Withholding?

(iii) US Patriot Act compliance?

5. Who has authority to bind Seller?

6. Are sale proceeds sufficient to pay off all liens?

III. THE PURCHASER:

1. Who is the Purchaser?

2. What is the Purchaser/Grantee’s exact legal name?

3. If Purchaser/Grantee is an entity, has it been validly created and is it in good standing?

(a) Articles or Incorporation – Articles of Organization

(b) Certificate of Good Standing

4. Is Purchaser/Grantee authorized to own and operate the Property and, if applicable, finance acquisition of the Property?

(a) Board of Director Approvals?

(b) Shareholder or Member approval?

(c) If foreign individual or entity, are any special requirements applicable?

(i) Qualification to do business in jurisdiction of the Property?

(ii) US Patriot Act compliance?

(iii) Bank Secrecy Act/Anti-Money Laundering compliance?

5. Who is authorized to bind the Purchaser/Grantee?

IV. PURCHASER FINANCING:

A. BUSINESS TERMS OF THE LOAN:

What loan terms have the Purchaser, as Borrower, and its Lender agreed to?

(a) What is the amount of the loan?

(b) What is the interest rate?

(c) What are the repayment terms?

(d) What is the collateral?

(i) Commercial real estate only?

(ii) Real estate and personal property together?

(e) First lien? A junior lien?

(f) Is it a single advance loan?

(g) A multiple advance loan?

(h) A construction loan?

(i) If it is a multiple advance loan, can the principal be re-borrowed once repaid prior to maturity of the loan; making it, in effect, a revolving line of credit?

(j) Are there reserve requirements?

(i) Interest reserves?

(ii) Repair reserves?

(iii) Real estate tax reserves?

(iv) Insurance reserves?

(v) Environmental remediation reserves?

(vi) Other reserves?

(k) Are there requirements for Borrower to open business operating accounts with the Lender? If so, is the Borrower obligated to maintain minimum compensating balances?

(l) Is the Borrower required to pledge business accounts as additional collateral?

(m) Are there early repayment fees or yield maintenance requirements (each sometimes referred to as “pre-payment penalties”)?

(n) Are there repayment blackout periods during which Borrower is not permitted to repay the loan?

(o) Is there a Loan Commitment fee or “good faith deposit” due upon Borrower’s acceptance of the Loan Commitment?

(p) Is there a loan funding fee or loan brokerage fee or other loan fee due Lender or a loan broker at closing?

(q) What are the Borrower’s expense reimbursement obligations to Lender? When are they due? What is the Borrower’s obligation to pay Lender’s expenses if the loan does not close?

B. DOCUMENTING THE COMMERCIAL REAL ESTATE LOAN

Does Purchaser have all information necessary to comply with the Lender’s loan closing requirements?

Not all loan documentation requirements may be known at the outset of a transaction, although most commercial real estate loan documentation requirements are fairly typical. Some required information can be obtained only from the Seller. Production of that information to Purchaser for delivery to its lender must be required in the purchase contract.

As guidance to what a commercial real estate lender may require, the following sets forth a typical Closing Checklist for a loan secured by commercial real estate.

Commercial Real Estate Loan Closing Checklist

1. Promissory Note

2. Personal Guaranties (which may be full, partial, secured, unsecured, payment guaranties, collection guaranties or a variety of other types of guarantees as may be required by Lender).

3. Loan Agreement (often incorporated into the Promissory Note and/or Mortgage in lieu of being a separate document)

4. Mortgage [sometimes expanded to be a Mortgage, Security Agreement and Fixture Filing]

5. Assignment of Rents and Leases

6. Security Agreement

7. Financing Statement (sometimes referred to as a “UCC-1″, or “Initial Filing”)

8. Evidence of Borrower’s Existence In Good Standing; including

(a) Certified copy of organizational documents of borrowing entity (including Articles of Incorporation, if Borrower is a corporation; Articles of Organization and written Operating Agreement, if Borrower is a limited liability company; Certified copy of trust agreement with all amendments, if Borrower is a land trust or other trust; etc.)

(b) Certificate of Good Standing (if a corporation or LLC) or Certificate of Existence (if a limited partnership) or Certificate of Qualification to Transact Business (if Borrower is an entity doing business in a State other than its State of formation)

9. Evidence of Borrower’s Authority to Borrow; including

(a) a Borrower’s Certificate;

(b) Certified Resolutions

(c) Incumbency Certificate

10. Satisfactory Commitment for Title Insurance (which will typically require, for analysis by the Lender, copies of all documents of record appearing on Schedule B of the title commitment which are to remain after closing), with required commercial title insurance endorsements, often including:

(a) Affirmative Creditors Rights Endorsement (extending coverage over policy exclusion 7 and policy exclusions 3(a) and 3(d) as they relate to creditor’s rights matters)

(b) ALTA 3.1 Zoning Endorsement modified to include parking

(c) ALTA Comprehensive Endorsement 1

(d) Location Endorsement (street address)

(e) Access Endorsement (vehicular access to public streets and ways)

(f) Contiguity Endorsement (the insured land comprises a single parcel with no gaps or gores)

(g) PIN Endorsement (insuring that the identified real estate tax permanent index numbers are the only applicable PIN numbers affecting the collateral and that they relate solely to the real property comprising the collateral)

(h) Usury Endorsement (insuring that the loan does not violate any prohibitions against excessive interest charges)

(i) other title insurance endorsements applicable to protect the intended use and value of the collateral, as may be determined upon review of the Commitment for Title Insurance and Survey or arising from the existence of special issues pertaining to the transaction or the Borrower.

11. Current ALTA Survey (3 sets), [typically prepared in accordance with 2005 Minimum Standard Detail for ALTA/ACSM Land Title Surveys, certified to the lender, Buyer and the title insurer, including items 1 through 4, 6, 7(a), 7(b)(1), 8 through 11(a) and 14 from the Surveyor's "Optional Survey Responsibilities and Specifications" referred to as "Table A"].

12. Current Rent Roll

13. Certified copy of all Leases (3 sets)

14. Lessee Estoppel Certificates

15. Lessee Subordination, Non-Disturbance and Attornment Agreements [sometimes referred to simply as "SNDAs"].

16. UCC, Judgment, Pending Litigation, Bankruptcy and Tax Lien Search Report

17. Appraisal (must comply with Title XI of FIRREA (Financial Institutions Reform, Recovery and Enforcement Act of 1989, as amended)

18. Environmental Site Assessment Report (sometimes referred to as Environmental Phase I and/or Phase 2 Audit Reports)

19. Environmental Indemnity Agreement (signed by Borrower and guarantors)

20. Site Improvements Inspection Report

21. Evidence of Hazard Insurance naming Lender as the Mortgagee/Lender Loss Payee; and Liability Insurance naming Lender as an “additional insured” (sometimes listed as simply “Acord 27 and Acord 25, respectively)

22. Legal Opinion of Borrower’s Attorney

23. Credit Underwriting documents, such as signed tax returns, property operating statements, etc. as may be specified by Lender

24. Compliance Agreement (sometimes also called an Errors and Omissions Agreement), whereby the Borrower agrees to correct, after closing, errors or omissions in loan documentation.

It is useful to become familiar with the Lender’s loan documentation requirements as early in the transaction as practical. The requirements will likely be set forth with some detail in the lender’s Loan Commitment – which is typically much more detailed than most loan commitments issued in residential transactions.

Conducting the Due Diligence Investigation in a commercial real estate transaction can be time consuming and expensive in all events.

If the loan requirements cannot be satisfied, it is better to make that determination during the contractual “due diligence period” – which typically provides for a so-called “free out” – rather than at a later date when the earnest money may be at risk of forfeiture or when other liability for failure to close may attach.

CONCLUSION

Conducting an effective due diligence investigation in a commercial real estate transaction to discover all material facts and conditions affecting the Property and the transaction is of critical importance.

Unlike owner occupied residential real estate, when a house can nearly always be occupied as the purchaser’s home, commercial real estate acquired for business use or for investment is impacted by numerous factors that may affect its use and value.

The existence of these factors and their affect on a Purchaser’s ability to use the Property for its intended use and on the Purchaser’s projected investment yield can only be discovered through diligent investigation and attention to detail.

The circumstances of each transaction will determine what degree of diligence is required. The level of diligence required under the circumstances is the diligence that is due.

Exercise Due Diligence.

R. Kymn Harp is a seasoned attorney based in Chicago, Illinois with 30 years experience representing commercial real estate investors, lenders and developers. He is a frequent speaker at continuing education seminars, and is a widely published author on commercial and industrial real estate topics including due diligence, entitlements, commercial real estate financing, and Brownfield development and financing.

R. Kymn Harp can be contacted at:

Robbins, Salomon & Patt, Ltd

25 E. Washington Street Suite 100

Chicago, IL 60602

Dir. Ph: 312-456-0378

Email: rkharp@rsplaw.com

For more information go to: http://www.realestate-law.com

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