The sonata-allegro form is used in many classical sonatas, concerti, and symphonies. The form provides a standardized road map to compositions, which makes them easier to analyze. The exposition, development, recapitulation always occur in the same order.
Presentation of themes and tonality, while critical to the music, is more fluid. Themes and the key of the music typically will appear multiple times, as they are woven into different parts of the composition. No matter how the themes and tonality are presented, the music cannot exist without them.
Financing arrangements are like the themes and tonality in a musical composition. Different aspects of the financing process occur at different points in the real estate transaction. Yet, most real estate buyers depend upon the money from mortgage lenders to buy the property; the real estate transaction cannot occur without financing.
This article is the fourth in a series about the Anatomy of a Real Estate Transaction. This article discusses the real estate financing process (Financing Period).
Financing Period Timing
In Anatomy of a Real Estate Transaction—Parts of the Transaction, I discussed the six major parts of a real estate transaction: Pre-Contract, Due Diligence Inspection Period, Financing, Closing Preparation, Closing, and Post-Closing. The Financing Period differs from the other five parts.
The other real estate transaction parts are sequential; they usually occur in the specified order in “serial.” However, calling the financing process the Financing Period is a misnomer. Rather than occurring at a specific point in the transaction, the Financing Period operates in “parallel” with the other parts. It usually overlaps at least two, and frequently, all of the other real estate transaction parts.
In a home purchase, the buyer may obtain a preapproval of their loan before they even look at properties. In a commercial real estate transaction, negotiating a purchase agreement and conducting due diligence is expensive. Therefore, some commercial real estate buyers will explore financing options before spending the funds required to negotiate a Contract and conduct due diligence.
Often, however, the buyers in both home and commercial transactions may wait until after they sign a Contract to approach prospective mortgage lenders. Occasionally, buyers may wait to obtain financing until after they have completed due diligence and are committed to purchase the real estate.
Real Estate Financing Process
Real estate financing includes both a debt and equity element. In a home purchase, debt financing generally includes obtaining a mortgage loan. The loan can be backed by a government agency, such as the Veteran’s Administration or Housing and Urban Development, or it might be from a bank or other commercial mortgage lender. The cash down payment made by the buyer is the equity in a home purchase.
In a commercial real estate acquisition, the buyer may negotiate both equity and debt financing with third parties. As I discussed in Different Membership Classes Can Help Meet LLC Financing Needs, there may be several classes of equity financing, besides a mortgage loan. This article, however, focuses only on debt financing.
Preapproval
For home purchases, many buyers obtain preapproval for a mortgage. A lender preapproval states the amount of a mortgage loan for which the buyer is qualified based upon income, assets, and credit history.
The preapproval shows the seller that the buyer is serious and is financially able to buy the home. However, a preapproval does not mean that the lender will loan money for the buyer to buy any home they want.
Commercial real estate purchasers do not undergo the preapproval process, as such. However, they may develop equity partner and lender relationships, and be able to evaluate lender appetite for a particular loan before making an offer to purchase a property.
Loan Application
Home purchasers will complete a loan application form. The buyers must provide information about the property they plan to purchase and their ability to repay a mortgage loan, including their assets, income, and liabilities. They may be asked to provide copies of pay stubs, tax returns, bank statements, brokerage statements, and child support orders. The lender also typically will verify employment status and the status of other income sources, such as retirement, alimony, or annuity payments.
The application process is more complicated for a commercial real estate loan. Commercial mortgage lenders usually expect the real estate, itself, to produce more than sufficient revenue to enable the borrower to repay the mortgage loan. Therefore, the borrower will need to provide all information for the lender to computer the real estate’s “earning capacity.”
Commercial mortgage lenders usually will require buyers to provide a rent roll or schedule leases, including a list of tenants, their lease terms, monthly rent amount, and whether the rent is being paid on time. The buyer also will require historical property financial statements, and a pro forma forecasting future financial performance.
Loan Approval
After receiving an application, the lender will evaluate the property and the ability of the borrower to prepay through a process called underwriting.
Depending upon the type of real estate, the lender also will conduct due diligence on the property. For a home purchase, the lender will order an appraisal to confirm that the property is worth at least as much as the purchase price. The lender will require a title report and survey or other proof that the buyer will own the property “free and clear.” The lender also will confirm it can be used as the buyer’s residence. And the lender will order a credit report and may verify employment.
A commercial mortgage lender also will require information about the borrower and the party. The lender will require an appraisal and title and survey, plus additional reports, which may be the same as those used by the buyer for its due diligence. The lender will order a property condition report, which describes the general condition of the real estate and establishes a recommended repair schedule. The lender frequently will use this repair schedule to determine the amount of a monthly replacement reserve payment, which the borrower will pay with its mortgage payments.
Commercial mortgage lenders also will order a Phase I environmental assessment (Phase I), which will evaluate whether there are serious environmental problem at the property. The lender may require inspections for specific concerns, including termite reports, radon testing, or mold inspection or testing.
Commercial mortgage lenders typically underwrite the loans based upon its debt service coverage ratio (DSCR). The DSCR is computed by dividing the property’s net revenue for a calendar quarter or other time period by its mortgage payment obligations for the same time period. A DSCR of 1:1 means that the real estate produces exactly the amount of net revenue to cover the borrower’s mortgage obligations. Most lenders require a DSCR of greater than 1:1, with high-risk loan possibly requiring a DSCR of 1.4:1.0 or greater.
Because commercial mortgage loans involve unique assets and usually contain more customized terms, they may pose a greater risk than a home mortgage. Therefore, most commercial lenders have a loan committee, which approves all loans. The loan committee will evaluate the loan terms and the property’s financial situation to evaluate whether the lender will approve the loan. The committee might also change the loan terms to make them more favorable to the lender. Because home mortgages must comply with preestablished terms, they rarely are subject to the committee approval process.
Loan Document Review
After the committee approves the mortgage loan, the lender will have an attorney prepare loan documents. At a minimum, the loan documents will include a note and a mortgage or deed of trust. For home mortgages, there will be a Closing Disclosure explaining the mortgage terms, actual cost of the financing, payment projections, and closing costs. There also may be certifications and affidavits which the buyer must sign confirming financial information and that the buyer plans to live in the home.
Most home mortgage lenders use standardized documents so the documents can be sold into the secondary mortgage loan market. Those loan documents are nonnegotiable. Therefore, the borrower’s review should focus on whether the loan terms (amount, interest rate, loan term, down payment amount, origination fee, prepayment terms, escrow requirements, etc.) in the documents match those which the borrower was expecting.
Commercial mortgage documents are more complicated. Like a home mortgage, there will be a note and a mortgage or deed of trust. Depending upon the type of property, there might also be an assignment of rents and leases, UCC financing statements granting a lien on personal property, guaranties, assignments of contracts, assignments or licenses or permits, and property- or borrower-specific certificates or affidavits.
Some commercial mortgages may be backed by HUD, Fannie Mae, or Freddie Mac (Agency Loans). Agency Loans also will require standardized documents. Sometimes, commercial borrowers can obtain approval for non-standard terms, but that can take time and cost money in additional legal fees.
Most other commercial mortgage loan documents are negotiated by the lender’s and borrower’s attorneys. But the secondary commercial mortgage loan market or the lender’s loan committee may limit the borrower’s ability to negotiate certain loan document provisions.
Loan Funding/Closing
After the parties have finalized the loan documents, the loan funding or loan closing will occur. Except with a refinance, this happens at the same time as the closing on the real estate real estate acquisition. Except for the number and type of documents involved, the process is similar for home and commercial real estate loans.
Most lenders will use an escrow agent, typically a title company, to handle the closing. The escrow agent will receive the loan proceeds and the buyer’s down payment and will have the borrower/buyer sign all loan documents. Upon the lender’s approval, the escrow agent will “break escrow,” release the loan proceeds to the seller and distribute and record the loan and acquisition documents with required government offices.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.
