Terminology in real estate financing can be very confusing to borrowers. There are a number of ways to get definitions of terms on the internet and a Google search can usually result in a quick explanation. My intent is to more fully explain some of the more common terms used in commercial real estate financing, and this list will be added to as terms come to mind and are used, and time allows. Please e-mail me if there is a term that you would like to have explained and I will do my best to explain it.
Amortization: The gradual elimination of a liability, such as a mortgage, in regular payments over a specified period of time. Such payments must be sufficient to cover both principal and interest. There is a set amortization period on loans….the time period that a loan will be paid off by regular payments specified by the lender in advance of the loan being funded or the close of escrow (25 year loan will be paid off in 25 years and the monthly payments are calculated accordingly).
Deed: A Legal document (instrument) by which an asset owner (the grantor) transfers his or her right of ownership (title) in an asset to another party (the grantee). To be enforceable, a deed must (1) state on its face that it is a deed, (2) accurately describe the property which is the subject matter of the deed, (3) be validly signed (executed) in presence of the prescribed number of witnesses, and (4) be handed over (delivered) to the grantee as a deed. Deeds may contain limitations or promises (covenants) which are enforceable even if unwarranted or not supported by a consideration. Some deeds (such as a deed of arrangement) serve as evidence of a pledge to carry out one or more specified actions, whereas others (such as a deed of protest) evidence that such actions have actually been carried out. Deeds are used in all states.
Estoppel Certificate: An instrument which itself prevents individuals from later asserting facts different from those contained in the document. Often required by the buyer of a commercial office building, an apartment complex, or a mobile home park. The tenant and landlord both sign the estoppel certificate, confirming the lease and pertinent facts thereto. Thereafter, neither party may make claims to the contrary. In some instances, the lender will require current estoppels at the close of escrow, so this should be addressed early on in the escrow process.
Fair Market Rents: The rent which would be normally agreed upon by a willing landlord and tenant in an “arm’s length transaction” for a specific property at a given time, even though the actual rent may be different. In a lease, the term “fair market rent” is defined in a number of different ways and is subject to extensive negotiation and interpretation.
Fixed Rate Mortgage: A loan in which the interest rate does not change during the entire term of the loan. For an individual taking out a loan when rates are low, the fixed rate loan would allow him or her to “lock in” the low rates and not be concerned with fluctuations. On the other hand, if interest rates were historically high at the time of the loan, he or she would benefit from a floating rate loan, because as the prime rate fell to historically normal levels, the rate on the loan would decrease. opposite of adjustable rate. To many buyers of commercial real estate, a low fixed rate is very advantageous as they can more accurately predict their expenses and income. However, in a time of high interest, an adjustable rate mortgage may be more advantageous in terms of cash flow in the early years of the property ownership. Often advice from a CPA is urged to see what is best for the borrower and their particular circumstances at that time.
Intermediary: Firm or person (such as a broker or consultant) who acts as a mediator on a link between parties to a business deal, investment deision, negotiation, etc. In money markets, for example, banks act as intermediaries between depositors seeking interest income and borrowers seeking debt capital. Intermediaries usually specialize in specific areas, and serve as a conduit for market and other types of information. Also called a middleman.
Jumbo Loan: A mortgage with a loan amount exceeding the conforming loan limits set by the Office of Federal Housing Enterprise Oversight (OFHEO), and therefore, not eligible to be purchased, guaranteed or securitized by Fannie Mae or Freddie Mac. OFHEO sets the conforming loan limit size on an annual basis.
Also referred to as “Jumbo Mortgage”.
Jumbo loans are often securitized by institutions other than Fannie Mae or Freddie Mac. These securities carry more credit risk than those issued by Fannie Mae or Freddie Mac, and therefore, trade at a yield premium which translates into slightly higher interest rates. However, in recent years the spread in interest rates between jumbo and conventional mortgages has been reduced.
Letter of Intent (LOI): There are potentially multiple uses of this term. Generally a written statement that two parties to a prospective transaction (buyer/seller or lessor/lessee) intend to proceed to a final agreement in good faith on stated principal business terms of the deal to be entered into. This meaning applies when executed by both parties. Alternatively such a document may be signed only by one party and is then an indication of a willingness to enter into agreement on the stated terms and conditions. To avoid legal issues regarding offer and acceptance and thus formation of a binding contract, care should be taken to include a clause stating that there is not a specific offer and no intent to be a legally binding obligation. However, an obligation to continue to negotiate in good faith to conclusion can be created. Often times an attorney may be consulted in writing a LOI.
Loan-To-Value (LTV): is the ratio of the fair market value of an asset to the value of the loan that will finance the purchase. Loan-to-value tells the lender if potential lossesdue to nonpayment may be recouped by selling the asset. For example, if the property to be purchased is $100,000 (fair market value) and the lender will loan $75,000 (loan amount), this would represent a LTV of 75%, which is a very reasonable loan for a commercial purchase. A 70% to 75% LTV is quite common for many commercial properties, with an 80% LTV being on the high side. Generally speaking, the lower the LTV percent indicates greater risk for the lender, and may result in a slightly higher interest rate or origination points for the borrower.
Operating Expenses: The cost of operating a commercial real estate property, such as an apartment or an office building, such as janitorial, management fees, utilities, and similar day to day expenses, as well as taxes, insurance, and a reserve for replacement of items which periodically wear out. These expenses should not include capital expenses such as roof replacement nor expenses associated with the production of income such as leasing commissions and legal fees or mortgage expenses.
Mezzanine Financing: A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. Mezzanine financing is basically debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full. It is generally subordinated to debt provided by senior lenders such as banks and venture capital companies.
Multi-Family Loans: These are loans that are used for the purchase of apartment buildings or mobile home parks, both of which are considered multi-family properties. A typical loan will have these characteristics, as an example, and each lender will have its own special features, and each property will be judged on its own condition, location, and overall profitability:
Multifamily loan LTV’s up to 85%
Loan terms up to 30 years
Flexible multifamily loan amortization rates, some up to 20 years
Potential for non-recourse multifamily loans
Low/no pre-pay penalties
Financing for mixed-use properties, such as a MHP that has an apartment complex as part of the entire property
Potential for assumable financing.
Points: Finance charges paid by the borrower at the beginning of a loan. One point is 1% of the loan amount. On commercial loans, points can vary greatly depending on the property, the income or investment history of the property, the borrower, the lender, and the amount of the loan. Quotes on Points are often given along with the interest rate quote on a proposed loan, and the dollar figure of the Points must be paid at the close of escrow, and may be considered as part of the Closing Costs, although it is technically a charge by the lender for the loan. If more than one lender is involved in making the loan, or if a loan broker separate from the actual lender is involved, each party could charge either a Point or a % of a Point. This should always be disclosed in the early stages of a loan application.
Pre-Payment Penalty (PPP): A penalty sometimes charged to a borrower who makes a prepayment on an existing loan. Pre-payment penalties are fairly common on most commercial real estate loans, and should be considered at the time of discussion about which loan is best for the borrower. A PPP can vary considerably with the lender, and can range from a few months interest on the loan up to a year’s interest, and more. And, a PPP usually has a time element, whereby the longer the loan is in place and in good standing, the lower the PPP becomes, up to a 10 year period from origination of the loan. Some lenders can waive a portion of the PPP, or the entire penalty, on an existing loan, so it is important that the borrower ascertain what are the PPP provisions in the loan they are considering. Some PPP provisions can also “kill a deal” if the seller of a property is unaware of the penalty, and it does not come up until the close of escrow on a pending sale.
Re-Financing: Re-financing means paying off an existing loan with the proceeds from a new loan, usually of the same size, and using the same property as collateral. In order to decide whether this is worthwhile, the savings in interest must be weighed against the fees associated with refinancing. The difficult part of this calculation is predicting how much the up-front money would be worth when the savings are received. Other reasons to refinance include reducing the term of a longer mortgage, or switching between a fixed-rate and an adjustable-rate mortgage. If there are prepayment fees attached to the existing mortgage, refinancing becomes less favorable because of the increased cost to the borrower at the time of the refinancing. For the most part, all commercial real estate is eligible for re-financing. Consulting your CPA is also advisable when considering this process.