Understanding loan servicing types and what to know before closing financing
In the world of capital markets, there’s no such thing as a free lunch. In line with how capitalism works, there’s value assigned to every component of a loan transaction, including loan servicing. When comparing financing options, borrowers understand the need to evaluate interest rates, loan-to-value thresholds, and loan term. However, many don’t realize it’s also extremely important to consider how the loan will be serviced when choosing a loan product or lender.
WHAT IS LOAN SERVICING?
Loan servicing is much more than just processing payments. This umbrella also covers draw processing, lease approvals, loan term changes, tax or insurance escrow processing, and pre-payment. Because there are many different types of loan servicing, there also are multiple business models for servicing companies.
IN-HOUSE SERVICING
A bank or a credit union – often a balance sheet lender – is likely to manage their own loan servicing in house. In this situation, the banker responsible for originating the loan is also in charge of a team that handles the intake and application of payments towards the loan, as well as escrow. This model is typical of full recourse lenders and doesn’t value the cost of loan processing separately from origination. Its one-stop-shop approach is usually the preferred servicing type for borrowers. First, because the transaction considers the lender’s relationship with the borrower, much of the business is done on a handshake basis. Second, because of the unconditional personal guarantees, these lenders may also be a bit more flexible in the loan terms. However, this model also can be a double-edged sword. Because the lender is also the servicer, it knows everything about the loan – good, bad, and ugly. Further, in our post-COVID world, amidst growing pressures from the regulators, lenders have tightened underwriting guidelines.
THIRD-PARTY SERVICING
For larger sized loans, outsourcing servicing to a third party becomes more common. As borrowers become more sophisticated in their businesses, seek larger loans, and increase their borrowing capacity, understanding how this servicing model works is critical for success. With third-party servicing, the servicing tasks are provided by another party as a separate service outside of origination. At the time of the sale of the loan, known as loan securitization, the loan’s servicing will be sold to the cheapest bidder. The companies buying the loan servicing are typically large-scale, low-cost providers such as Midland, PNC, Wells Fargo, and Greystone. These firms have pools of employees located in low labor cost markets who oversee servicing of thousands of loans. Tasks are compartmentalized for greater economies and efficiencies, with one area managing cashiering and loan payment, another area processing draws, etc. This specialized servicing model allows national servicers to offer lenders low-cost servicing while still making a small profit.
Selling the servicing separate from the loans to the actual bond buyers, also allows CMBS, debt fund, and life company lenders to lower the ultimate spread on the loan extended to the borrower by separating the loan’s credit risk from its operational risk. In a typical CMBS pool, servicing is sold for 5 to 7 basis points of the loan. For this negligible price, lenders can keep the lion’s share of the loan’s spread to compensate for the credit risk.
For borrowers, the downside to thirdparty servicing is there’s no personal borrower-to-lender relationship to leverage. The servicers and their processors are hired simply to follow the loan documents like the letter of the law. This can create problems for non-institutional and unsophisticated borrowers accustomed to haggling with lenders or expect to be able to negotiate servicing components after a loan is closed. Fortunately, with the right preparation during loan origination, borrowers or their intermediary can take advantage of some nuances within the third-party servicing model. These preventative efforts can save borrowers heartache by providing some flexibility in an otherwise inflexible loan transaction process that accompanies a capital markets transaction.
One clause often negotiated upfront is “deemed approved,” or the amount of time servicers have to respond or provide an approval for any future changes to the original loan documents. Agreeing to the timing upfront essentially gives borrowers recourse against long delays waiting for answers from the servicer. A typical deemed-approved clause reads that if the response from the servicer isn’t received within five business days, the approval is deemed approved, and the borrower can continue his or her plans without servicing repercussions.
How draw requests for a hotel PIP or retail property tenant improvement allowance are handled is another area where upfront negotiation can benefit the borrower. The loan docs often can be adjusted to allow the sponsor or borrower to claim draws in advance, without having already spent the money.
TAKE ADVANTAGE OF EXPERT RESOURCES
The types of servicing models don’t end here. There are other approaches used such as correspondent servicing where the mortgage banker services the loan themselves, or a hybrid servicing model where the payment processing happens at a central processing facility but any major decisions on the loan are approved by the lender itself. To fully explore the breadth of servicing scenarios and risk accompanied with each model, borrowers should arm themselves with the best information. An expert intermediary who has successfully negotiated borrower-favorable servicing-related clauses upfront and knows the advantages and disadvantages of each option as they related to the specific loan transaction can be a difference-maker for protecting property owners from unnecessary risk while positioning them for ongoing success.
