Commercial FinancePublications

From Dreams to Deals: Avoiding Pitfalls in Commercial Real Estate Financing

October 30, 2023Articles
Indianapolis Business Journal

In commercial real estate transactions, time is money, execution is everything and projects generally do not move forward without a mortgage loan. Lenders and their counsel should view a project as if the lender is the eventual buyer, owner and seller. For developers, considering the transaction from a lender’s point of view can save them considerable time and money and expedite loan closing.

Commercial Leases

Many commercial real estate projects contemplate an income stream from commercial tenants.  In such cases, in addition to analyzing the lease, a lender will most likely require that the owner and tenant execute a subordination, non-disturbance and attornment agreement that:

(i) subordinates the lease to the mortgage,

(ii) stipulates that the lender will not disturb the tenancy in a foreclosure if the tenant is not in default under the lease and

(iii) requires the tenant to recognize the lender as a successor landlord upon foreclosure.

There are several potential conflicts between the tenant and lender, such as lender notice and cure rights for landlord defaults, lender’s liability as a successor landlord, tenant’s alteration rights, use of casualty/condemnation proceeds and sub-leasing and assignment restrictions. The lease may also be inconsistent with the lender’s loan documents.

Secondary Financing

If a developer anticipates using secondary financing as a portion of the capital stack for its project, and especially if such financing is secured by a mortgage or is mezzanine financing secured by a pledge of ownership interests in the project owner, then the senior lender will most likely insist that the subordinate lender enter into an intercreditor agreement that sets forth the rights and priorities between the lenders. There can be a number of areas of contention between the senior lender and the subordinate lender within the intercreditor agreement, including:

(i) rights of the subordinate lender to receive payments on its loan,

(ii) the maturity date of the subordinate loan vis-à-vis the senior loan,

(iii) provisions related to the obligation of the subordinate lender to “stand still” with regard to exercising remedies upon a default and

(iv) the right of the lenders to amend and/or increase their indebtedness without the other lender’s consent.

There may also be programmatic limitations on the type of secondary financing permitted (i.e., hard or soft pay) and/or the format of the intercreditor agreement depending upon the type of senior financing (i.e., GSE or HUD-insured financing programs).

Ground Leases

A ground lease can be used as another form of financing from a land seller to a developer. A ground lease may have some advantages to the seller because it can preserve its interest in the real estate beyond a foreclosure by the mortgage lender and provide control over the development and use of the property. A developer should negotiate to limit the landlord’s ability to default the tenant under the ground lease and include generous notice and cure provisions, both to the tenant and to any lender of the tenant. Some lenders have extensive ground lease requirements that should be considered at the outset.

Cross-Easements and Declarations

Projects often require temporary or permanent rights to adjacent land or space, which can be as simple as off-site easements or as complicated as declarations or condominium regimes for multi-phased or multi-use developments. Even if developer affiliates control those off-site parcels or spaces, a developer should be prepared to put these agreements in place to provide lenders with assurance that the legal rights they confer will continue to exist in the event the project and off-site parcels no longer have common ownership due to a voluntary transfer or foreclosure. While drafting such instruments, the parties should:

(i) analyze any operating covenants and use restrictions to determine whether they are consistent with the proposed use and development of the phases,

(ii) ensure that any shared operational costs are equitably allocated amongst the parties and

(iii) scrutinize any provisions concerning design approval, financing restrictions, lien rights, control, use of casualty/condemnation proceeds and transfer restrictions or other preemptive rights that may limit a developer’s ability to obtain financing.

If lenders, developers and their counsel address these issues at an early stage, then delays and unnecessary costs can often be avoided.