Overview Mortgage Application Lender's Review of Application Mortgage Commitment Due Diligence Appraisals The Replacement Cost Approach The Market Data Approach The Income Approach to Value Engineer's Report Underlying Documents Promissory Note Debt Service Variable Interest Rate Loans Terms of the Promissory Note Mortgage Provisions Representations, Warranties and Other Clauses
Overview
Obtaining a loan secured by a mortgage on commercial real
estate is not an easy or fast procedure. Every step of the
process is complicated; even something as simple as
identifying the lender requires a time-consuming
investigation. The potential borrower initiates the
mortgage application process by contacting the lender or
the lender's correspondent in order to determine whether
the lender is presently in the market for making mortgage
loans. If the lender is making mortgage loans, the
borrower has to determine whether the lender is making
loans (1) in the amount that the borrower is seeking to
borrow and (2) secured by the kind of property that the
borrower owns or is purchasing, and (3) in the location in
which the borrower's property is located. If so, the
lender or its correspondent will send the lender's
standard form of loan application to the borrower.
The first step in obtaining a commitment for a mortgage
loan is for the borrower to prepare a written mortgage
application, which identifies the borrower and provides
information upon which the lender can make a preliminary
credit analysis. The purpose of the loan application is to
provide a written request by the borrower for the loan in
a format that indicates the borrower and the terms of the
proposed loan and provides the lender with the facts
relating to the proposed loan and the property that will
become the security for the loan. The application is
usually prepared on the lender's form of application,
which, if ultimately approved by the lender, will be
converted into a loan commitment. The loan commitment will
then be returned to the borrower for acceptance,
rejection, or modification. At such time as the borrower
believes that the commitment is in an acceptable form, the
borrower will execute and return it to the lender together
with the commitment fee, and then the lawyers can begin
preparing for the loan closing. However, a great deal of
time, effort, and money will be expended before the lender
will be ready to fund the loan.
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Mortgage Application
Although the mortgage application appears on (and in) the
lender's form, the mortgage application is considered an
offer by the borrower to the lender i6 take out the loan,
and is not binding on the lender until the loan commitment
is issued and is executed by the lender and accepted by
the borrower. Frequently, even after the proposed
commitment is issued, the borrower will attempt to make
changes to the terms of the loan or the required loan
documents or closing procedure. If the lender finds 'that
the borrower's changes are acceptable, the lender will
execute the commitment. If not, it is returned to the
potential borrower for additional modifications.
In the event the lender is not satisfied with the loan
application or wants to change the terms of the loan, the
lender either will request additional information or may
attach a rider to the loan application containing the
additional terms and require the borrower to execute the
rider to confirm its approval of the additional terms.
The traditional loan application requires a great deal of
information about both the borrower and the property that
will be the security for the loan. This information would
usually include the following: The identity of the borrower and is principals and their business background and real estate experience Certified financial statements and tax returns for the borrower and its principals The credit history of the borrower and its principals relating to other loans A detailed description of the property, its present and intended use, and any alterations that the borrower will be making to the property Copies of any leases or lease commitments that have already been executed for portions of the property A survey of the property A title report For the property A topographic and geological study of the property An engineer's report of the structural components of the existing improvements on the property An environmental report for the property Photographs of the property Renderings of the property after the construction is completed If the application is for permanent financing, copies of de existing loan documents or a copy of the construction loan commitment or information regarding the construction or interim lender The amount and terms of the requested loan A current appraisal of the property by an independent appraiser Feasibility and demographic studies of the property Information relating to the zoning for the property A budget for the property, including projected income, operating expenses, and real estate taxes A copy of the mortgagor's purchase contract and closing report for the property A pro forma financial statement for the property If the owner is a corporation, copies of the corporation's certificate of incorporation, by-laws, minutes, and information regarding its officers, directors, and shareholders If the borrower is a partnership or a joint venture, a copy of the partnership agreement, partnership certificate, and information regarding the general and limited partners, including financial statements of any general partners
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Lender's Review of Application
Each lender has its own criteria for determining when to
make a mortgage loan, which h applies according to its own
procedures and standards. Although it is beyond the scope
of this book to analyze the economics of any particular
property or the economic decision making of any lender as
to whether it will make a loan, it is important to
consider the basis for such a decision.
Initially, the lender will make a general determination
that (1) the borrower is someone with whom the lender
wishes to do business, (2) the property is located in an
area that appears to be growing, (3) the improvements are
adequate and properly constructed, (4) the proposed
tenants are sufficiently credit worthy, and (5) the
location of the property is appropriate in the geographic
area and there is a sufficient demand for space and a low
enough vacancy rate in the area so that it is more likely
than not that the project will be successful. The lender
will then determine the total value of the property upon
which the principal amount of the loan will be based.
There are a number of ways of calculating value, including
comparing the property to a similar property that has
recently sold and the cost of replacing the improvements
on the property. However, the method that lenders are most
comfort able with is calculating the net income being
generated from the property and capitalizing that income
based upon the then prevailing market rates for a return
on an investment in real estate. In order to calculate
value, one must divide the capitalization rate into the
property's net income. Accordingly, if the then current
capitalization rate is 10% and the net income from the
property is $200,000 a year, then the value of the
property would be $200,000 divided by 10%, which equals
$2,000,000. Therefore, the higher the net income from the
property or the lower the capitalization rate is, the
higher the value of the property and the mortgage loan
will be. There is a correlation between interest rates and
capitalization rates so that when interest rates rise the
appropriate capitalization rate would also rise because an
investor in real estate could earn a higher return on this
investment through a bank deposit if the interest rate is
higher then the capitalization rate. Similarly, as
interest rates reduce, so too does the required
capitalization rate.
Subsequent to establishing the value of the property, the
lenders utilize their own loan-to-value ratio in order to
determine the appropriate amount to lend against the value
of the property. There are self-imposed limitations by
lending institutions and there are limitations imposed by
the federal and state banking boards on the appropriate
loan-to-value ratio. These limitations are frequently
somewhere between 75% of value and 90% of value. However,
the lenders can sometimes be convinced to increase their
loan-to-value ratio if other criteria are met. These would
include the relationship between the loan amount and the
gross rentable area or the amount of the loan as a
multiple of gross income or the amount of the loan as a
multiple of net income or the dollar value of rentals from
credit tenants compared to the actual operating costs and
debt service of the property. Lenders may also consider
the relationship of cash flow to debt service and the
relationship of debt service and operating expenses to
gross income. Finally, lenders will also consider sales
prices or comparable properties as well as the borrower's
track record. Naturally, borrowers want an increase in the
loan-to-value ratio so that they have the most leverage
from the property.
The most important factors for the lender to consider are
not as easily determinable as the fair market value of the
property. These factors include (1) the reputation, net
worth- integrity, and business acumen of the borrower (or
its principal owner), (2) the lender's estimate of the
need for the particular property being financed in the
community in which it is located. (3) the physical
condition of the improvements on the property, (4) the
lender's comfort with the tenants or the anticipated use
of the property, (5) competition in the area for similar
properties, and (6) whether the borrower's financial
projections seem reasonable and conservative in light of
general economic conditions.
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Mortgage Commitment
Once the lender has examined the mortgage application and
is satisfied that, based on the borrower's credit history,
the credit risk is minimal and that it is more than likely
that the loan and the interest thereon will be repaid in a
timely fashion, and that the loan fits within the lender's
then current criteria for mortgage loans, the lender will
issue a loan commitment. The purpose of the loan
commitment is to provide assurances to the borrower that,
if the conditions of the commitment are satisfied and the
lender obtains a valid security interest in the property
that will be the security for the loan, the loan will be
funded. The borrower and its attorney should utilize the
commitment as a map to prepare for the loan closing since
it will contain a listing of the items required for the
closing.
If the commitment is for a permanent loan that will be
replacing construction financing, the commitment will have
to be in a form that is acceptable to the construction
lender before the construction lender will agree to
advance funds. The concern of the construction lender
is that it will fund the development and then, because of
the technical requirements of the permanent loan
commitment or the weak financial condition of the lender,
the permanent lender will not fund the loan and the
construction lender will not be taken out of the
construction loan. Accordingly, the borrower must examine
the permanent loan commitment and discuss its contents
with both its permanent lender and its construction lender
prior to finalizing and accepting the commitment.
The permanent loan commitment will usually contain the
terms of the loan, including: (1) the amount. of the loan
(2) the properly to be mortgaged, (3) the interest rate,
(4) the maturity date, (5) the monthly debt service
payments, and, most importantly, (6) the expiration date
of the commitment. The permanent loan commitment will also
contain the lender's closing requirements which will
usually include: (1) the amount and kind of title
insurance that the lender wants to receive, (2) the
casualty and liability insurance that the lender wants the
borrower to maintain, (3) an undertaking by the borrower
to Pay all of the lender's expenses in closing the loan,
and (4) the borrower's confirmation that the lender can
cancel the commitment if the buildings and other
improvements are not completed or are destroyed by a
casualty, or the property is condemned.
The lender would also want to have the right to approve
any assignment of the loan commitment or any modification
in the plans or specifications for the improvements.
Traditionally, the permanent lender will want to keep the
term of the loan commitment as short as possible in order
to avoid a situation where it is committed to lend funds
at a certain interest rate and, due to fluctuations in the
interest rate market between the time the commitment is
issued and the time the mortgage is funded, the
commitment's interest rate or other terms become
unattractive. This could result in the lender being unable
to sell the loan in the secondary market or being unable
to obtain loan participants (i.e., colenders) without a
significant discount. Conversely, the construction lender
will want the term of the permanent loan commitment to
contain as long a term as possible in order to provide the
construction lender with the ability to be taken out of
the loan regardless of how long; it takes the borrower to
complete the project. It is, of course, to the borrower's
best interest to negotiate for as long a term on the
permanent loan commitment as possible.
Frequently, if the lender is unwilling to negotiate for a
longer term, the borrower can negotiate to pay an
additional fee in order to obtain the approval of the
lender to extend the term of the commitment. It is common
For the borrower to be required to pay a commitment fee to
the lender at the time the commitment is issued as
consideration for keeping the Funds available prior to the
funding. The amount of the commitment fee is frequently
tied to the size of the loan and the nature of the
interest rates. For example, a fixed rate usually carries
with it a higher commitment fee than an adjustable rate in
order to compensate the lender for the risk it is taking
in the event of a fluctuation in the interest rate market
during this period of time.
One additional factor that should concern the borrower in
the mortgage commitment is the economic conditions
relating to the funding of the loan. This means that if
the loan commitment is conditioned upon the borrower
entering into a certain number of leases or a certain
number of tenants occupying their space before the loan
will be funded, the borrower is running the risk that in
the event the rental market becomes soft it will not be
able to fund the loan at the same time as the construction
loan has terminated. In order to protect itself in this
instance, the borrower can negotiate for the loan
commitment ~o provide for multiple fundings based upon the
percentage of the property that is leased at any
particular time.
Another form of loan commitment is a stand-by commitment,
which is used when a borrower is unable to obtain
financing and, nevertheless, wants to proceed with the
development. The stand-by lender receives a fee but does
not expect to be required to fund the loan. The borrower
pays the fee and obtains a commitment for the stand-by
loan in the expectation that the mortgage market will
improve and that it will be able to obtain a permanent
mortgage commitment at a mote favorable interest rate
prior to the time that the construction is completed. The
stand-by commitment will contain far more onerous terms
for the borrower due to the fact that the lender is a
lender of last resort and would prefer to make a short-
term loan rather than be committed to a long term.
A typical mortgage commitment will contain all of the
salient provisions of the Loan and will also describe the
documentation that the borrower will need to provide for
the closing. The commitment itself should contain the
following provisions:
The name and address of the borrower and, if the borrower is an entity, whether the borrower is a partnership or a corporation, the state in which the borrower is incorporated or filed within, and whether or not the borrower is qualified to do business in the state in which the property to be mortgaged is located. Whether the lender is making the loan based upon its obtaining a security interest in any additional property. Whether the lender is to receive a guaranty by the principals of the borrower or the corporate parent of the borrower. Whether the loan is conditioned upon certain specific leases being executed, or the execution of a construction loan commitment, and the required terms of such leases or construction loan commitment. The payment provisions of the proposed loan, including the amount of the loan, its term, the interest rate, payment provisions, and prepayment limitations. The name of the lender's counsel and the fact that the borrower has to pay the lender's counsel's fees. The default provisions that will be included within the loan documents. The requirement that the borrower accept the commitment by a certain date and close the loan by a certain date or the commitment expires. The expiration date of the commitment. A brief description of the mortgaged property and the fact that the loan is conditioned upon the lender receiving a first lien on the land and buildings and improvements without any liens or security interests affecting the lender's position. The fact that the borrower will be required to obtain title insurance for the lender at the borrower's cost and that the title will be good and marketable and the mortgage will be a valid first lien on the property. The borrower will have to provide the lender with an as built survey of the mortgaged property, which survey demonstrates that the property abuts a public street or has access to a public street and indicating on the survey the location of all buildings, improvements, easements, and other limitations. The obligation of the borrower to supply certificates of occupancy or the local equivalent and whatever licenses and permits are required to permit the property to be used in the manner in which the borrower intends to use it. Proof that the property is in compliance with all federal, state, and local environmental requirements and that there are no toxic or hazardous substances on the property or in the buildings. Evidence that the property has received the proper local zoning approval or that a subdivision nap has been filed, or that local approval is not necessary. Copies of all executed leases, as well as an assignment of the leases to the lender. Satisfactory evidence that the borrower has authority to enter into the loan and execute the loan documents. Any conditions for the commitment relating to the financial position of the borrower. The fact that all real estate taxes must be paid at the closing and the establishment of tax escrows to pay future taxes Satisfactory proof that the property is covered by required insurance, which usually includes fire insurance with extended and additional cover. age, sprinkler, boiler, rent or business interruption, public liability, plate glass, flood, and any other relevant insurance on the business, including workers' compensation. The fact that the loan will not close a any part of the property is subject to a condemnation proceeding. The lender's right to declare the loan in default( if the borrower attempts to sell the property or to place any additional liens on the property. The borrower's agreement to pay all costs, fees, and expenses relating to the mortgage closing and any obligations of the borrower to pay a commitment fee. The borrower's confirmation that the lender has the right to cancel the commitment in the event that any of the provisions of the commitment or the application turn out to be incorrect, or there is a material adverse change in the borrower's or tenant's financial condition, or the property is damaged in any way, or any litigation exists, which could have an adverse financial position on the borrower. A provision that the loan commitment cannot be assigned without the lender's consent. The condition that the borrower supply an opinion of counsel to the effect that the borrower is duly organized and authorized to do business, there is no threatened or pending litigation that might affect the property, all local laws and regulations have been complied with, the contemplated transaction does nor violate the by-laws or partnership agreement or other documents placing obligations on the borrower, the borrower is not in violation of any law or agreement, the loan documents as executed constitute a valid binding obligation of the borrower, which is enforceable, and the loan documents when recorded provide the lender with a valid first lien on the property.
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Due Diligence
Introduction
Before the lender will agree to provide financing for any
property, it will proceed will a detailed investigation of
the property. The purpose of this due diligence review, is
to enable the lender to learn everything there is to know
about the borrower and the property. The due diligence
review is intended to provide the Lender with enough
information about the borrower and the property to avoid
unhappy surprises and to obtain confirmation of everything
the lender has been told about the property and the
borrower by the borrower, the borrower's mortgage broker,
and the mortgagee's correspondent. No mortgage loan is
made without an extensive due diligence investigation.
Generally, the purpose for the lender's due diligence
review is to enable the lender to identify any possible
problems inherent in the ownership, management, and
operation of the property prior to making the loan. The
lender conducts the due diligence investigation of the
property as if it were a potential owner of the property,
because it wants to understand the risk it is obtaining in
order to be prepared in the event of a default by the
borrower. For that reason, the lender will not make a
loan secured by a property that has a significant
potential for having serious problems. However, in
addition to identifying potential problems in the
ownership, management, and operation of the property. The
purpose of the lender's due diligence review is to make
certain that the lender's lien will include every valuable
portion and aspect of the property, as well as to make
certain that the lender's counsel obtains the requisite
documentation relating to the property.
The due diligence investigation includes an inspection of
the property (structural engineer's report, environmental
engineer's report, topographic and geological studies), an
appraisal of the property, an economic analysis of the
operation of the property, and an analysis of the
important documents relating to the property (e.g., leases
and title documents). The Lender's due diligence review
will also include a physical inspection of the property
and gathering information relating to the borrower and the
tenants or other potential users of the property.
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Appraisals
Although the purpose of an appraisal is to determine the
fair market value of the property, an appraisal only
provides an estimate of value, rather than a precise
value. Appraisals are usually prepared by licensed
appraisers; who are members of the American Institute of
Real Estate Appraisers or other similar organizations. A
thorough appraisal can lake as long as a month to prepare
since the appraiser must look at the property and do
research in the !locality where the property is located in
order to obtain comparable sales figures.
In order to estimate the fair market value of a specific
property, the accepted professional procedure is to
utilize three different approaches. These are the
Replacement Cost Approach, the Market Data Approach, and
the Income Approach to Value. The appraiser will then
weigh their comparative worth and correlate this data into
a final estimate of value.
The following is are brief summaries of the methods utilized
to arrive at each of the three primary approaches to a
property's value.
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The Replacement Cost Approach
1. Estimate the value of the land.
2. Estimate the replacement cost of the existing
structures on the property. The replacement cost of an
improvement is the cost or reproducing the improvement on
the basis of current prices, and assumes the construction
of a structure having equal utility. It may or may not be
the cost of a replica of the property. The actual cost
estimates for the replacement of the improvements are
obtained by reference to a nationally recognized cost
index, such as "Marshall Valuation Service." 3. Estimate total accrued depreciation on the existing
improvement caused by physical depreciation, functional
obsolescence, and economic obsolescence. 4. The total amount of the accrued depreciation is then
deducted from the replacement cost of the improvements in
order to arrive at a current appreciated value of the
improvements. To this figure the value of the land is
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The Market Data Approach
1. Investigate the market as to recent sales of similar
properties, preferably in nearby locations, but ranging as
far as necessary in order to obtain a comprehensive
picture of the value of comparable properties.
2. Consider all listings, offerings, and/or rental data
as they may affect current economic conditions. 3. Confirm each sale with public records and ascertain
the validity of the sales price as being based upon an
arms-lengrh transaction, including - the terms of the sale
and whether there were motivating factors for the sale. 4. Analyze and compare all of the sales, listings, and
rental data as they apply to the subject property in light
of existing market conditions. 5. Adjust each sale where the property is dissimilar to
the subject property in important aspects, such as
location, time of sale, size of property, or the condition
of the property. The purpose is to make each sale as
nearly equal to the subject property as possible; thereby
forming a value range and indicating an overall price or a
per unit bracket. 6. Finally, select several sales which appear most
reflective, and formulate an opinion of the value of the
subject property based upon this market study. go to top
The Income Approach to Value
1. Income Data: Institute a thorough search of the market
to ascertain the economic rent. Seek out similar
properties both leased and offered for lease, and from
this data obtain a current fair market rental. This rental
may be on either a "gross" or a "net" basis depending upon
the type of property under appraisement and on local
custom as shown by market research. Vacancy rates and
velocity of absorption should also he analyzed here in
order to arrive at an effective rental.
2. Expense Data: Research all sources of expense
categories. This is done by utilizing the subject
property's past history. (where applicable), its
comparison with known expenses on similar buildings, and
cross checking with published journals which give
"averages" for building types and locations. Wherever
possible, of course, actual expenses such as taxes,
insurance costs, management, and other items, are
factually verified . The total expenses thus obtained are
deducted from the effective income to arrive at an annual
net income figure for the subject property.
3. Income Capitalization: For the purposes of this
paragraph, capitalization is the process of converting
into a present value the right to receive a series of
anticipated future annual installments of net income.
Dividing the net income by the Capitalization Rate
produces a Capitalized Value by the Income Approach. Since
the subject is currently Leased and the capitalization
rate (the relationship between income and sales price)
will have been extracted from market sales, this rate,
when applied to the subject's income, will produce a value
indication.
4. Gross Rent Multiplier: A gross income or gross rent
multiplier (GRM) is. a factor reflecting the relationship
between sale price or value and the gross annual income of
real estate. It is arrived at by dividing the sale price
by the income. Since the GRM relates value to gross income
rather than net income, its use is valid only for types of
properties that are:
Reasonably consistent in net to gross income operating ratios, and Sell with sufficient frequency in the market to produce a discernible pattern.
Additionally, to be useful for a GRM analysis, the
properties must be reasonably similar in age, size,
remaining economic life, and operating expenses. The
principal advantage of this approach is that the
reflection of rental income is direct and any differences
between properties, which could involve adjustments based
on judgment estimates, have been resolved by the free
action of the rental market. This approach not only
neutralizes the effect of unknown sophisticated financing
techniques benefiting a particular property, but also
eliminates aberrations caused by one property having some
advantage over another property in age, condition,
accessibility, location, or physical characteristics. The
difference in actual rental presumably reflects the extent
of this advantage as viewed in the market. go to top
Engineer's Report
Before agreeing to provide financing, one of the lender's
requirements will be that at least one engineer inspect
every component of the building and every improvement on
the property in order to insure the structural integrity
of the improvements and their compliance with the local
building codes and fire safety requirements. If the
property is about to undergo construction, the lender will
be concerned over the land and its ability to absorb the
new buildings and improvements.
An engineering inspection of the existing improvements
should include four aspects: the building envelope, the
common elements, the interior of the building, and the
building's essential services. The envelope consists of
the exterior walls, windows, chimney, and roof, while the
common areas include the parking and other exterior areas,
and essential services include the plumbing, heating,
ventilating, air conditioning, electrical services, and
elevator or escalator. Finally, the interior refers to
the walls, ceilings, fixtures, floors, and doors. Each of
these portions of the building should be carefully
examined by an engineer and covered in the written report
that must be delivered as soon after the inspection as
possible. The report should not only describe the current
physical condition, but also contain an estimate of the
component's remaining useful life and the cost of
replacement.
It should also be noted that there are different kinds of
engineering inspections as well as different kinds of
engineers and different levels of inspections. The
engineers that could be called into an inspection of a
large commercial property would include a structural
engineer, an electrical engineer, an elevator engineer, a
systems engineer, a surveyor, a geologist, a limnologist
(if there is water on the property), an environmental
engineer, and other subspecialty engineers to look at
specific components of the building.
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Underlying Documents
In the event the property being financed is subject to
superior mortgages or inferior mortgages, ground leases,
operating leases, or other agreements that will not be
terminated as part of the financing, or in the event they
contain onerous terms, then the mortgagee will review
these documents to determine the potential problems
inherent in placing a lien against and, possibly,
acquiring such a property in the future. The three most
important kinds of documents that must be reviewed are
mortgages, ground leases, and operating leases. The
following lists these underlying documents and their
components that must be reviewed:
Pre-Existing Mortgages Due on Financing Clause Notice to Existing Mortgagee Ground Lease Term Subordination Use Casualty and Condemnation Rent Construction Obligations Mortgaging, Assigning, and Subletting the Leasehold Recording Operating Lease Term Rent and Additional Rent Rent Escalation Clauses Reimbursement of Expenses Allocation of Expenses Percentage Rent Common Area Expenses Tenant's Right to Rent Offsets Repairs, Maintenance, and Alterations Casualty to the Premises Insurance Condemnation Use of the Property Sublease, Assignment, and Leasehold Financing Fee Mortgages Indemnification and Liability Insurance
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Promissory Note
Introduction
The loan is evidenced by a promissory note from the
borrower to the lender that contains a promise by the
borrower to repay the loan to the lender: In order for the
note to be enforceable, it must be a written promise to
pay a specific sum of money that is executed by the
borrower to the order of the lender and payable either on
demand or on a specific date. In addition to the
foregoing, a promissory note will usually contain detailed
payment terms, including the interest rate, contain a
reference to the fact that the promissory note is secured
by a mortgage or deed of trust, describe the conditions
that constitute a default, and state whether there are any
grace periods, late payment charges, or an equity
participation by the lender. The promissory note does not
create a security or other interest in the property and is
rarely recorded except as an exhibit to the mortgage if
required by local law. Alternatively, the loan may be
evidenced by either a mortgage note or a bond - each of
which is the same as a promissory note, although a bond is
a more formal instrument, and, in some states, a stamp tax
may be due when a bond is executed. .
The form of the promissory note is less significant than
its terms. Both the borrower and the lender will want (o
be certain that the terms contained in the note are
identical to the terms of the commitment letter, if any,
and to the parties' understanding of the terms of the
loan. This is particularly true of the terms regarding the
structure of the debt service payments, the maturity date
of the loan, and whether the note will be self-liquidating
during its term or require a balloon payment on maturity.
Because the loan is evidenced by the promissory note,
except under extraordinary circumstances, its provisions
will be binding on both the borrower and the lender. A
common misperception is that because the mortgage is
recorded and the promissory note is not, a borrower might
believe that the terms of the mortgage are more important
than those contained in the promissory note. However, this
is not the case - at the very least, the mortgage will
refer to the promissory note and will provide that a
default under the promissory note will be considered a
default under the mortgage, just as a default under the
mortgage will be considered a default in the promissory
note. A sample promissory note secured by a deed of trust
or mortgage is here.
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Debt Service
Debt service is the periodic payment of the principal and
interest due on the loan. Although loans are Frequently
paid in monthly installments of principal and interest,
they do not necessarily have to be. A loan may or may not
requite regular payments of interest and principal or may
accrue the interest for a future payment and may not
contain any amortization payments at all. Amortization is
the process whereby the indebtedness is reduced or
eliminated by the regular payment of the principal portion
of the debt service. A loan will amortize more quickly
with an increase in the portion of each debt service
payment that is attributable to the reduction of the
principal indebtedness or by towering the interest rate
and maintaining the same debt service payment. For
example, a $1 million loan can self-liquidate in 15 years
at 10% interest with monthly payments of $10,746.05, or in
12 years at 7.86% interest with the same monthly payment
of $10,746.05, or in 20 years at 8.22% interest with
monthly payments of $8,500.00.
A loan can be either fully amortizing, in which event the
loan self-liquidates during its term, or the loan can
require a balloon payment on the maturity of the loan
(i.e., at the end of the term of the loan), or the loan
can provide for negative amortization, in which case the
interest that accrues during the term of the loan is added
to the principal and not paid until maturity. A self-
liquidating loan will be completely amortized or paid off
during its term in constant equal monthly, quarterly, or
annual debt service payments. In the event there is a
balance of principal due on the maturity of the loan which
is in excess of the regular monthly installment payment,
the payment of that balance is a balloon payment and must
be paid to the lender on maturity. If a loan is calculated
to be repaid in equal installments over 30 years (i.e.,
having: a 30 year amortization schedule), the loan would
self-liquidate over 30 years if all of the payments were
made. However, if the same loan is paid back on a 30-year
amortization schedule, but is due and payable in 10 years
or ran be called by the lender in 10 years, then that loan
will have a substantial balloon payment even though the
amortization schedule is self-liquidating.
The reason for using a 30-year amortization schedule in a
10-year loan is to allow the borrower to make
significantly smaller monthly debt service payments during
the term of the loan. If the original amount borrowed is
$100,000 and the interest rate is 12%, in 30 years the
loan would completely self-liquidate in 360 equal monthly
installments of $1,028.61 or a total repayment of
$370,299.60 paid over 30 years. However, if the loan is
due and payable in 10 years but its repayment is still
based upon a 30-year amortization schedule, the borrower
will have to pay the lender $1,023.61 per month for 120
months (or a total of $123,435.20 in monthly installments
during the 10 years) and a final installment of $93,918.49
10 years after borrowing the money, or total payments over
10 years of $216,851.29. Conversely, if the loan is being
repaid over 10 years using a 10-year amortization
schedule, then the monthly payments would be $1,434.71 and
the total amount paid over 10 years would be $172,165.14.
Therefore, repaying the loan pursuant to a 10-year
amortization schedule saves the borrower $44,686.15.
Moreover, the borrower would save $198,194.46 in debt
service by repaying the indebtedness using a 10-year
amortization schedule rather than a 30-year amortization
schedule.
In addition to the smaller amount of debt service that has
to be paid, there is another benefit to the borrower in
exacting a self-liquidating mortgage. In a non-self-
liquidating indebtedness, when the loan matures and the
balloon payment has to be repaid, the borrower will have
an obligation to satisfy the indebtedness regardless of
whether it has the money or has to obtain the proceeds
elsewhere. If the borrower is unable to make the balloon
payment, the mortgagee will foreclose the loan and the
borrower will lose the. property, regardless of how much
in debt service the borrower has already paid to the
lender. In the event the borrower is required to refinance
the mortgage (i.e., obtain a replacement mortgage), the
borrower will have to use all or a significant cam portion
of the proceeds of the refinancing to make the balloon
payment on the original mortgage and will then have a
continuing obligation to the new mortgage holder.
One of the most interesting (and costly) characteristics
of debt service payments is the actual cost and the
resulting effect of the interest paid over the term of the
loan. As indicated above, in repaying a loan of $100,000
at 12% interest in equal monthly installments over 30
years, the borrower would be obligated to pay $370,299.60
at the rate of $1,028.60 per month. However if the loan is
repaid over 10 years using a 30-year amortization
schedule, the borrower will pay $216,851.69 (i.e.,
$1,023.61 per month for 120 months plus a $93,418.49
balloon payment).
Part of the reason for the confusion in understanding the
effect of the interest rate on the aggregate debt service
payments is the fact that a loan does not amortize in the
same amount each year. In the early years of a loan the
debt service payment is almost all interest, and as the
interest component of debt service decreases each year,
the principal portion of the payment increases. this
accelerates over time as the loan gets closer to maturity.
The following chart demonstrates this effect by showing
the application of a constant debt service payment of
$1,321.51 per month at periodic dates over the term of a
10-year loan of $100,000 at 10% interest:
| Month # | Interest Portion of Payment | Principal Portion of Payment | Loan Balance | | | | | | 1 | $833.33 | $488.17 | $99,511.83 | | 2 | 829.27 | 492.24 | 99,019.58 | | 12 | 786.67 | 534.84 | 93,865.82 | | 24 | 730.67 | 590.84 | 87,089.30 | | 36 | 668.80 | 652.71 | 79,603.20 | | 60 | 524.95 | 796.56 | 62,197.23 | | 90 | 299.76 | 1,021.74 | 34,949.96 | | 110 | 115.29 | 1,206.21 | 12,629.04 |
You can use our Maximum Commercial Real Estate Loan Analysis
and Amortization Spreadsheet to vary these terms and amounts.
In the early years of the loan there is very little
principal amortization, whereas toward the end of the term
the interest allocation of each payment becomes much
smaller. Because the payments are constant, each month as
the interest payment- is getting smaller the amortization
payment is getting larger. This is caused by the fact that
as the loan amortizes. less of the debt service payment is
being applied toward interest and more toward principal.
This change is very small at the beginning of the term and
grows each month until the last third of the loan term,
when the amortization portion of the debt service payment
becomes larger than the interest portion, which escalates
the repayment of the loan. Moreover, each month as the
principal gets smaller the interest on the remaining
portion of the loan becomes smaller than the previous
month, which means that an even larger portion of the debt
service can be applied to amortization.
In addition to self-liquidating loans and loans with
balloon payments, there are other formats that can be used
in repaying an indebtedness, including: (1) standing loans
(in which only interest, not principal, is repaid during
the term); (2) accruing interest loans (where all or part
of the interest is not paid during the loan term and is
then added to the principal balance of the loan, which can
result in having a loan payable on maturity that is in
excess of the original amount borrowed); and (3) reverse
payment loans (whereby each debt service payment is used
to pay the principal rather than the interest, which has
the effect of enabling the borrower to repay large amounts
of principal in the early years, that decreases over time
as the interest portion of the debt service payment
increases: however, this reduces the amount of the
available interest deduction for taxes in the early
years).
Whether the lender will insist upon a standing loan, a
balloon loan, or a fully amortizing loan will depend upon
the economic environment at the time the loan is made.
Standing loans entail the most risk of default only
because the principal balance is never reduced. A fully
amortizing loan involves less risk due to the fact that
over a period of time the loan is automatically repaid,
which also means that each month the borrower's equity
increases and the difference between the value of the
property and the outstanding balance of the loan
increases. A balloon loan which provides for some
amortization is basically a ' compromise between a
standing loan and fully amortizing loan and is usually
utilized when ether the lender requires a shorter loan
term in order to adjust the interest rate to market
conditions or the borrower requires cash flow from the
property, which would not be payable if it was used to pay
principal amortization, and there appears to be a minimal
risk to both parties.
It should also be noted that a loan that has a balloon
payment due or a maturity date that is shorter than the
amortization schedule does not necessarily have to be
repaid when it matures. The shorter term provides the
lender with the ability of renegotiating the interest rate
a( the point in time when the loan matures and enables the
lender to respond to changing market conditions at that
point in time either by increasing the interest rate or by
refusing to refinance the property if the value has
decreased. The shorter maturity date provides the lender
with flexibility and the ability to react to a changing
lending environment.
As far as interest rates are concerned, the interest rate
on a particular loan and the form it will take will depend
upon market conditions at the time the loan is repaid. If
credit is tight when the loan is funded, the interest rate
will be high the term of the loan may only be for 5 years
but with a 25- or 30-year amortization schedule because
the lender will have control over the situation. Conversely, when there is a surplus of mortgage money
available, the interest rates will be lower and borrowers
will be able to obtain 25-year amortization terms so that
their loans will self-liquidate. Periodically, in response to
fluctuating interest rates, lenders may insist upon
adjustable interest rates as a condition for making
loans. Adjustable or variable rate mortgages protect the
lenders from losing money when, during the term of a loan,
the borrower of a fixed rate loan is paying a lower
interest rate than the lender has to pay to obtain funds.
Interest rates in variable interest rate or adjustable
interest rate obligations adjust automatically after
specified periods of time (e.g., annually or every 3-5
years) in an attempt to reflect fluctuations in the prime
rate, the bond rate, or another market index.
In calculating debt service, there are only three
variables - the amount borrowed, the interest rate, and
the term of the loan. However, each of the three variables
can have a profound effect on the amount of the debt
service payment. The lower the interest rate or the longer
the loan term, the lower the constant payment will be. If
$100,000 is borrowed for different terms and at different
interest rates, the monthly debt service payment
fluctuates as follows:
Monthly Payment to Amortize a $100,000 Loan | Term in Years | | Interest Rate | 10 | 15 | 20 | 25 | 30 | | | | | | | | 8% | $1,213 | $956 | $836 | $772 | $734 | | 9% | 1,267 | 1,014 | 900 | 839 | 805 | | 10% | 1,322 | 1,075 | 965 | 909 | 878 | | 10.5% | 1,349 | 1,105 | 998 | 944 | 915 | | 11% | 1,377 | 1,137 | 1,032 | 980 | 952 | | 11.5% | 1,406 | 1,168 | 1,066 | 1,016 | 990 | | 12% | 1,435 | 1,200 | 1,101 | 1,053 | 1,029 |
Furthermore, as indicated earlier, as the term of the loan
is extended and the monthly payment is reduced, the
aggregate debt service payment made by the borrower over
the life of the loan increases dramatically.
The significance of these fluctuations in monthly payments
becomes even more dramatic and the economic effect of a
longer repayment schedule becomes more obvious if an
examination is made of the aggregate amount paid to
amortize each of the loans described above.
Aggregate Debt Service Payment to Self-liquidate a $100,000 Loan
| Term of Repayment in Years | | Interest Rate | 10 | 15 | 20 | 25 | 30 | | | | | | | | 8% | $145,560 | $172,080 | $200,640 | $231,600 | $264,240 | | 9% | 153,040 | 182,520 | 216,000 | 251,700 | 289,800 | | 10% | 158,580 | 193,500 | 231,600 | 272,700 | 316,080 | | 10.5% | 161,880 | 198,900 | 239,520 | 283,200 | 329,400 | | 11% | 154,360 | 204,660 | 247,680 | 294,000 | 342,720 | | 11.5% | 168,720 | 210,240 | 255,840 | 304,800 | 356,400 | | 12% | 172,200 | 216,000 | 264,240 | 315,900 | 370,440 |
If the $100,000 is borrowed at 8%, the amount that has to
be repaid in. from $145,560 if the loan has a 10-year
amortization schedule to $264,240 the loan is repaid on a
30-year amortization schedule, while the payments on the
$100,000 loan at 12% increase from $172,200 if repaid in
10 years to $370,440 if payment is made over 30 years. It
should also be noted that at 8% interest, the payments
over 30 years are 82% greater than over 10 years, while at
12% the payments over 30 years are 115% greater than over
10 years.
Accordingly, the proposed payment schedule should be
carefully examined in order to be certain that a schedule
is chosen that optimizes the borrower's position over the
long term. Moreover, borrowers should consider periodic
prepayments because a small amount of the loan prepaid
each month can have a dramatic effect of the total amount
paid over the life of the loan. If, for example, one were
to borrow $100,000 for 30 years at 9% interest, which
requires a debt service payment of $805 per month, by
prepaying an additional $100 a month, the loan amortizes
in less than 20 years, thereby saving the borrower $75,268
in debt service because the borrower would be paying an
extra $23,700 during the initial 19-3/4 years and would
not have to pay the $98,968 in debt service that would
have had to be paid over the remaining 10-1/4 years if no
prepayments had been made. The result is a very
significant savings for a relatively small monthly
payment.
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Variable Interest Rate Loans
In times of economic uncertainty, especially in periods of
high inflation and fluctuating interest rates, lenders
frequently attempt to protect the return on their loan
portfolios by lending money based on variable -interest
rates rather than fixed payment terms and interest rates.
There are numerous variations of the variable or
adjustable rate loans, including the following most
commonly utilized variations:
Adjustable Mortgage Loans
The interest rate is based upon a particular index and
fluctuates periodically as the index changes. In order to
reflect the fluctuating interest, the loan term, debt
service, and/or principal balance will change during the
loan term.
Variable Rate Mortgage
The interest rate fluctuates together with the market
interest rate, and the debt service payment also
fluctuates in order to maintain the same amortization
schedule with the new interest rate.
Variable Payment Mortgage
A standing mortgage loan in which the interest rate
fluctuates with the loan market.
Graduated Payment Mortgage
In order to assist new entries into the borrowing market,
the loan rate is kept low for one or more years and then
increases in steps to a market rate of interest.
Deferred Interest Mortgage
In order to accelerate the payment of the debt, the
principal is paid first and the interest rate accrues
without interest and is paid after the principal.
Callable Loans
In order to protect the interest rate, the loan is
callable periodically after an initial period enabling the
lender to reexamine the rates if a Long-term rate no
longer reflects the market.
Appreciation Mortgages
The lender obtains a participation in the profit on the
sale of the property in order to compensate it for lending
the money at an interest rate that is below market.
Notwithstanding the popularity of these alternative
payment provisions, the parties should ascertain before
using them that they arc permissible in the jurisdiction
in which the property is located. Some of the variations
require enabling legislation to circumvent limitations in
various stale laws. Another problem with their use is that
variable rate mortgages are non-negotiable pursuant to the
Uniform Commercial Code because they do not represent the
promise to pay a certain sum of money. Also, the promise
to pay an additional sum of money could be considered an
optional advance not covered by the original mortgage
financing and wind up being subordinate in lien priority
to sums advanced under a junior mortgage.
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Terms of the Promissory Note
As indicated earlier, there is no standard form of
promissory note, although there are quite a few provisions
that uniformly appear in the body of a promissory note.
The terms and provisions that will almost always be
contained within the promissory note include the
following:
The name or the borrower or maker. The name of the payee or holder. The payee's address or the location at which the payment are to be made. A promise to repay de indebtedness. The amount that has been or will be advanced. The interest rate or a formula for calculating the interest rate. The debt service payment or a Formula for calculating the debt service payment. The maturity date. Whether the interest will be calculated based upon a 360-day year or a 365-day year; the use of the former will marginally increase the return that the lender will receive. The manner in which the debt service will be applied; whether it will be applied first toward the principal or the interest. Whether the note is secured and, if so, the nature of the security instrument and the location of the collateral. The amount of a late charge, if any. The grace period after the due date of the payment after which the late charge is due. Whether the lender has to provide written notice of a default to the borrower. The interest rate that will be payable by the borrower after a default in making a debt service payment or performing the terms of the loan. Whether a prepayment will be permitted and, if so, during what period of time the prepayment can be made, whether it can be a partial prepayment or only a prepayment of the entire indebtedness, and whether there is a prepayment penalty due upon making a prepayment. Whether a default by the borrower will be considered a prepayment necessitating the payment of the prepayment penalty together with the outstanding principal indebtedness. Whether the borrower will be obligated to pay the lender's attorneys' fees after a default. Whether the borrower waives presentment for payment, demand, protest, notice of nonpayment, default, or dishonor. The fact that the failure of the holder to insist upon strict performance by the borrower should not be considered a waiver by the holder of strict performance. The waiver by the borrower of all benefits that may accrue to it due to statutes of limitations and any moratorium, reinstatement, marshaling, forbearance, valuation, stay, extension, redemption, appraisement, exemption, and homestead rights under the law. An indication of what state law the promissory note will be interpreted under. A provision that the interest due under the promissory note shall not exceed applicable usury statutes. and that if the interest should exceed the applicable usury statutes, then the excess interest would be applied in reduction of the principal indebtedness. To whom notices should be sent, and the manner of sending notices. Whether the promissory note or other loan documents will create personal liability for the borrower or the loan contains an exculpation provision. That the promissory note cannot be modified without a written agreement. That the term borrower should also include successors.
The promissory note must be executed by the borrower, and the signature should be, but is not required to be acknowledged. go to top
Mortgage Provisions
A mortgage or deed of trust is a pledge of real estate
securing a debt that is evidenced by a promissory note.
The mortage, which is a security instrument, has no
significance withour an executed promissory note and an
unpaid debt. Moreover, the mortage, as a security
instrument, has no effect on the legal title to the
property, unless the promissory note is not paid when it
matures, the debt service payments are not made when they
become due, or the mortgagor (the borrower) violates one
of the other provisions of the mortgage and the mortgagee
(the lender) declares a default, accelerates the
indebtedness, forecloses the mortgage, and sells the
property. Alternatively, the mortgage ceases to be a lien
on the property upon satisfaction of the debt. Every
state and many localities have their own form for
mortgages or other security instruments providing a lender
with a security interest in real property located in that
locality. In order to be enforceable, the mortgage or
other security instrument must comply with the applicable
state law in its form, content, execution, delivery, and
recording.
There are certain provisions that are almost always found
in mortgages and are essential for the mortgagor, the
mortgagee and a third party examining the mortgage to
understand the relationship of the parties to the property
and each other. The mortgage will usually recite the
parties, the amount of the loan being secured, the
obligations of the borrower to repay the loan, and the
borrower's obligation with regard to the operation and
maintenance of the real estate. Most importantly, the
mortage must contain an exact legal description of the
property that is actin as the security for the
indebtedness. The mortage should also provide the
mortgagee with a lien an all personal property that is
used with the real property. In addition to the
foregoing, mortgages usually contain the following
provisions:
A granting clause in which the mortgagor conveys a lien on the real estate to the mortgagee. Representations and warranties by the borrower (mortgagor) as to its interest in the property and the fact that the property is free and clear of other liens, except those elaborated in a schedule annexed to the mortage. A defeasance clause in which the mortgagee agrees that upon payment in full of the principal indebtedness and the interest thereon, the mortgage shall be automatically void. An elaboration of the events of default and the mortgagee's rights in the event of a default by the mortgagor - the traditional defaults include nonpayment of principal, interest, taxes, or ground rent, default in paying a superior mortgage, waste of the property, structural alterations without the mortgagee's consent, and/or the mortgagor's failure to maintain insurance or to adhere to any of the other conditions of the mortgage. An obligation of the mortgagor to perform all of it obligations under any leases on the property and to maintain the property in good repair. An agreement by the mortgagor that the mortgagee's failure to enforce any of its rights is not a waiver of such rights of enforement. An agreement by the borrower not to sell, lease, or alter the property without the lender's consent. An agreement by the borrower to adhere to all of the loan documents.
It is important to keep in mind while reviewing the
various portions of the mortgage that much of the broadly
written protection is intended to provide the mortgagee
with some assurance that regardless of what happens during
the 5-30-year term of the mortgage, the morgagee and its
interest in the property will be protected. It is because
the mortgagee is making a long-term commitment to the
property that the provisions of the mortgage must
anticipate inconceivable contingencies.
The following lists the provisions that are commonly found
within a mortgage or deed of trust:
Preamble Date of the mortgage Name, type of entity, and address of the mortgagor and the mortgagee Statement that promissory note has been executed for a certain amount of money Indication that the mortgagor is providing the mortgagee with a security interest in the property as collateral for the repayment of that indebtedness Identification of the property by a legal description of real estate (or as an exhibit) Statement that the mortgagor is holding all of the foregoing interests for the benefit of the mortgagee and its successors and assigns until such time as the indebtedness evidenced by the promissory note and all interest theron are repaid in full A compendium of property rights.
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Representations, Warranties
and Other Clauses
A reaffirmation of information that was
previously supplied by the mortgagor to the
mortgagee.
Title Warranties - including the fact that the
mortgagor owns fee title to the property.
General Representations If mortgagor is an entity, it is duly
organized and legally existing and is in good
standing in its state of organization
Mortgagor has good and marketable title to
the property and the right to execute the
loan documents and that this will not
create a default under any other
agreement to which the mortgagor is a
party.
Real Estate Property Taxes
This clause requires the mortgagor to escrow
property taxes (any and all taxes assessed
against the property) with the mortgagee in
advance of their due date or provides an
event of default if the mortgagor does not
make the tax payment prior to a lien being
placed on the property.
Insurance and Casualty
An enumeration of the insurance that the
mortgagor must maintain while the mortgage is
a lien on the property.
A description of the nature of the policies and
the carrier that the mortgagee wants the
mortgagor to have and utiltize.
Condemnation
Typically in the event of a condemnation of all
of the mortgaged property, the
indebtedness secured by the mortgage will
be accelerated and the condemnation
award will first be used to satisfy the
mortgage on the property, and the balance, if
any, will be paid to the owner of the
property.
Events of Default
Will occur if a debt service payment is not made
on its due date or if the mortgagor or its
tenants do not perform all of their
obligations as described in the mortgage
Obligations include the payment of taxes and
assessments, the mortgagor's maintenance of
the property, and maintaining adequate
insurance.
Mortgagor wants to accelerate the indebtedness
and commence foreclosure as quickly
after a default as possible.
Mortgagee wants written notice and an
opportunity to cure those things which could be
considered a default.
Restrictions on Sale or Financing
Due of Sale clause or Due on Encumbrance clause
enables to the lender to decare the loan
due and payable, notwithstanding the
absence of a monetary or performance default
by the borrower, in the event the property
is sold or is subsequently encumbered by a
subordinate mortgage.
Exculpation
Limits the borower's liability on the promissory
note and the mortgage to its interest in the
property securing the indebtedness and the
lender agrees not to seek a personal
judgment against the borrower.
Dragnet Clauses
Provides that the note evidences, and the
mortgage secures, the indebtedness described in
the note and all other indebtedness between
the borrower and the lender.
Prepayment
A mortgagor is generally not permitted to prepay
all or any part of a mortgage loan unless
it is permitted by the express provisions
of the mortgage.
Maintenance and Repairs
Requires that the mortgaged property be properly
maintained and repaired by the mortgagor at all
times Contains a standard as to what is considered
a necessary repair or item of maintenance.
Cross-Default Provisions
Protects the lender in the event that there is a
default relating to only one property in
situations where the loan is secured by
several properties.
Assignment of Least and Rent
Mortgagee receives an unconditional assignment
of the leases and rents from the property
Mortgagor usually collects the rent and other
income from the property's tenants unless
and until there is a default by the
mortgagor. Also use our Commercial Real Estate Financing Tools:
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