Underwriting is the crux of any commercial real estate financing transaction. During this process, debt and equity providers initiate a series of fact-gathering and verification activities, known as due diligence, to gain insight on the property and sponsor (the person who owns and/or controls the asset being financed). The steps involved to move a transaction from initial term sheet to settlement statement to ultimate closing can vary by type of loan and type of lender. Understanding upfront how each capital source underwrites can guide borrowers to choose the right loan product for their situation and asset. Not only does this knowledge alleviate unnecessary anxiety at the start of the transaction, it also helps borrowers avoid potentially deal-killing surprises further down the road.
There are two main due diligence processes that correlate to the two main lending products: non-recourse and full-recourse loans. Non-recourse loans through capital sources such as CMBS conduits, debt fund bridge lenders, and life insurance companies typically don’t require sponsors to put up personal guarantees other than those against fraud or bad boy acts. Instead, non-recourse lenders focus on the property being financed. Conversely, full-recourse loans through banks and credit unions require the sponsor or owner to financially guarantee the performance of the loan fully and unconditionally and care very little about the actual asset. Because of the difference in focus and risk, non-recourse and fullrecourse lenders approach due diligence differently.
UNDERWRITING NON-RECOURSE LOANS
Commercial mortgage-backed securities (CMBS) are one of the most popular sources of non-recourse loans with approximately $100 billion of annual CMBS loan originations. Like non-recourse bridge loan lenders and life insurance companies – as well as preferred equity, mezzanine debt lenders and joint venture equity partners – CMBS lenders follow a very detailed underwriting and due diligence process. They will independently verify an asset’s cashflow, leases, and, in the case of hotels, any franchise agreement. They rely heavily on the appraisal, environmental report, and property condition report. Many of these lenders also leverage outside underwriting firms to confirm an asset has sufficient ongoing cashflow available to service the loan.
Although non-recourse lenders primarily focus on the asset, any transaction sponsor with more than 20% ownership interest in an asset will undergo a background search. When outstanding litigation is uncovered, it presents a challenge for the lender and can even derail the transaction. To avoid this predicament, sponsors would be wise to engage an experienced intermediary who can structure around any negative or inconsistent information and keep the transaction moving forward. Good intermediaries will be able to anticipate questions that will be asked during due diligence and frontload that information for a smoother, faster transaction.
Because non-recourse loans are guaranteed by the property, there’s a series of legal processes that go hand in hand with the above due diligence to ensure the lender has a perfected lien against a clean title of the asset. The lender’s legal team will confirm that the asset’s survey matches its title and that there are no inconsistencies in information or documentation. To ensure their interests are represented and keep the transaction on track, borrowers should engage their own legal representative who has experience successfully closing non-recourse loans.
UNDERWRITING FULL-RECOURSE LOAN
Banks and credit unions almost always require full recourse on their loans. Unlike their institutional non-recourse lending counterparts, a recourse lender is less worried about the actual real estate and more concerned about the borrower’s ability to make payments and eventually pay off the loan. As a result, full-recourse loans carry unconditional borrower guarantees. No matter what happens in the future, the borrower is on the hook personally to fulfill his or her debt obligations. Before approving a transaction, the financial institution’s loan committee will validate the borrower’s income and liquidity by scrutinizing personal tax returns and bank statements and may also require a deposit relationship.
Because the borrower has pledged unconditional personal guarantees, loan committees are more willing to work around issues uncovered during due diligence than non-recourse lenders. The committee knows its financial institution is insulated from issues that arise during the life of the loan, including those due to missed items during underwriting. However, if any members of the loan committee have negative bias against a deal, the transaction could be rejected. Borrowers can improve their ability to get to the closing table by working with an experienced intermediary who has a direct relationship with the financial institution and the loan committee members.
BECOMING A MORE SOPHISTICATED BORROWER
As commercial real estate and hotel owners gain experience, they can graduate to non-recourse financing. Going through the due diligence process required to close a non-recourse loan institutionalizes the borrower’s team and prepares commercial real estate and hotel owners to scale their business and pursue more and larger transactions.