Debt

Debt, also known as a loan, is how much of commercial real estate is funded. Most investors borrow around 50-65% of the total cost of the property from a lender to complete the purchase of a property.

As with other aspects of commercial real estate, there is a significant amount of jargon associated with debt and loans.

Debt & Loan Jargon

Term: the length of the loan, typically expressed in years. (e.g. “3+1+1” is a three year loan with two one year extensions.)

Fixed Rate Loan: interest rate is fixed for the entire loan. Fixed rate loans tend to be longer than floating rate loans.

Floating Rate Loan: interest rate changes at a fixed frequency (ex. monthly) in accordance with an index.

Index: a specific measure that changes over time.

10-Year Treasury Rate: example of an index. Comes in other durations like 1 and 5 years. Reflects the “risk free” rate because tied to the US government. 4.29% as of Feb 2024. 3.38% as of March 2023.

SOFR (Secured Overnight Financing Rate): example of an index often used for floating rate loans. Replaced the index LIBOR. 5.32% as of Feb 2024. 0.30% as of March 2022.

Fed Funds Rate: Reflects the costs bank charge each other to borrow funds overnight. When people say “the fed increased interest rates”, this is what they are referring to. The federal government uses this to control inflation (increase) and stimulate the economy (decrease). 5.33% as of Feb 2024. 0.25% as of March 2022.

Basis Points or “bps”: A portion of a percentage point where 100 bps is equal to 1.00%; often used in relation to the interest rate on a loan (e.g., “250 bps over SOFR” means 2.50% over SOFR).

Point: 100 bps or 1%. (e.g., “The lender is going to charge a point origination fee”.)

Spread: the interest rate above an index. Examples:

SOFR + 2.50% = 2.50% above the SOFR rate of 4.80% = 7.30% interest rate (floating rate).
5-Year Treasury + 1.90% = 1.90% above the treasury rate of 3.30% = 5.20% interest rate (fixed rate).

Origination Fee: fee charged by a lender to give the loan.

Interest Only Loan: a loan without amortization (repayment of principal each month).

Hedge: typically a cap or a swap.

Cap: an agreement between a borrower and a 3rd party to establish the maximum amount a floating rate index (SOFR) can increase. (e.g. a 6.00% cap on SOFR for 2 years). The borrower pays a one-time fee to the 3rd party of the cap.

Swap: an agreement between a borrower and a 3rd party to convert a floating rate index (SOFR) to a fixed rate for a specific period of time. Money is exchanged between parties whenever the index adjusts. Both parties are making a bet on whether interest rates will increase or decrease. A borrower may want a swap to reduce uncertainty.

Template

Download template here: Debt Jargon Cheat Sheet

Loan Agreement Structure

A summary of items with ** are often included in a 5-10 page term sheet

Definitions: many legal documents are full of “defined terms”. This is especially true for joint venture and loan agreements. A defined term in typically a word that is capitalized and has a specific meaning that may or may not be like the normal definition of the word.

Example: “capital expenditure” and “Capital Expenditure”. The latter would be a defined term that would either be (a) listed before the first use of the term or (b) listed in a separate list of definitions. “capital expenditures” may mean different things to different people whereas “Capital Expenditures” will be specifically defined as “in accordance with generally accepted accounting principles” or similar. Very important: don’t assume the meaning of a defined term. Read the definition.

Typical Documents for a Loan: there are many documents that are tied to a loan. Typically, the “loan agreement” is the main operational document. This structure and abstract template is designed for the main operational document. See below for other documents included in many commercial loans.

General

Property**: [name of property(ies) associated with the loan]
Lender**: [name of lender]
Amount**: [list both total loan amount as well as initial loan funding amount]
Servicer: [this is the day to day contact; could be lender or 3rd party]
Borrower(s)**: [list legal entity name(s)]
Guarantor**: [list legal entity name(s); specify if full recourse or “bad boy” acts & environmental only]
Closing Date**: [closing date of the loan]
Term**: [list length of the loan; ex. 3 years]
Expiration Date**: [date loan expires; ex 6/30/2028]
Extension Options**: [list any extension options; ex. 2 x 1 year extension]
Payment Date**: [list the monthly due date of payments (ex. 1st of month), grace period before late fee (ex. 7 days), and late fee amount (ex. 5%)]
Place of Payment: [list address and payment entity]
Amortization**: [indicate if interest only or amortizing; if amortizing, at what interest rate]
Interest Rate**: [indicate index (ex. SOFR) if applicable and spread; if fixed at certain interest rate, indicate this (ex. one month SOFR + 3.00% or 5.75% fixed]
Interest Rate Cap**: [indicate cap/swap on index, if applicable, and expiration of cap (ex. 3.00% SOFR cap until 6/30/26)]
Default Rate: [list default interest rate]

Reserve & Impounds Accounts**

For value add properties, there could be reserve accounts. These reflect loan proceeds that are held back from the initial loan closing for use in the future. Examples:

Leasing: used for future leasing costs – tenant improvements and commissions.
Capex: used for specific property improvements that were identified prior to closing such as roof replacements, asphalt repairs.
Interest: there may not be enough cash flow to pay the debt service until the property is fully leased. This reserve would cover the interest costs until the property is stable. Ex. lender requires an 18 month interest reserve.

Similar to reserve accounts, impound accounts are separate allocations for specific costs. The difference is that they are paid monthly by the borrower in addition to the interest costs. Examples:

Property Tax: large amount paid 1 to 4 times per year.
Insurance: large amount paid once per year.
Capex: could be a way for the lender to get comfortable that there will be funds to pay for unforeseen capex. Ex. borrower pays $0.10 per square foot per year on a monthly basis.

There will be a specific process the borrower must comply with to take money from an account.

Representations & Warranties, Covenants

Representations and warranties are statements by the borrower that certain things are true at time of the loan document execution. Examples:

The borrower is a legal entity that is not in default or bankruptcy.
The information provided to the lender is accurate to the best of borrower’s knowledge.
There is no material adverse change in the financial condition of the property.

Covenants put affirmative (“have to”) and negative (“can’t do”) restrictions on the borrower. Examples:

Comply with laws.
Allow lender to inspect the property.
Maintain required insurance.
Use proceeds from property to pay debt service.
Report to the lender as required.
Lease according to requirements (see below).
Maintain at least a [1.20] debt service coverage ratio each quarter.

Don’t commingle funds with other properties not associated with this loan.
Don’t add more debt without lender’s approval.
Don’t lease to cannabis tenants.

Leasing Approvals & Guidelines**

These could be requirements under a loan:

Approval required for: indicate if all leases or just some (ex. above certain SF).
Necessary Info Submitted for Approval: indicate what info must be submitted and when lender must respond by.
No approval required on leases: indicate if there are any leases that do not require lender approval.
Minimum leasing guidelines: there may be restrictions on leases that do not require lender approval.

Defaults

This section describes what qualifies as a default, the notification process, the ability to cure a default, and what happens if a default is not cured. Examples of default:

Not paying debt service.
Not getting lender approval on a major lease.
Fraudulent reporting.
Not carrying insurance.

Prepayment Options**

Indicate if borrower has right to prepay the loan; if so, what is process and cost?

Partial Release / Early Sale(s)**

For loans with multiple properties on separate legal parcels, the borrower may want the ability to sell one or more of the properties, but still keep the loan in place on the other properties. The following would be addressed in the loan agreement.

- Are partial sales/releases possible? If so, under what conditions, costs and procedure?
- Are there specific release prices associated with specific properties?
- Is there acceleration of the loan beyond the amount allocated to the property being released (ex. 120% of the allocated loan amount)? If so, how is the accelerated paydown allocated to the other properties?

Extension Options**

Any extension options? If so, indicate notification period, cost and conditions for extension.

Reporting Requirements

This can be very simple or detailed. There will likely be monthly, quarterly, and annual components. Reporting could include the following:

Cash flow statement
Income statement
Balance sheet
Debt service coverage ratio (DSCR) test. DSCR = NOI divided by debt service (ex. 1.20). The lender typically has a definition of how to calculate DSCR.
Debt yield test. Debt yield = NOI divided by loan amount (ex. 9.3%).
Annual appraisal with loan to value test (ex. max 70% loan to value).
Annual audit by third party

Other

Cash Management Agreement: Is there one? In place day one or springing in cases of default? This gives the lender control over all the revenue.
Cash Flow Allocation: Does the lender require a priority of payments of expenses. Example:

Property operating expenses.
Debt service.
TI, commission, and capex expenses due.
Reserve and impound account funding.
Distributions to borrower.

Securitization**: Does lender have right to securitize loan? Are costs passed through to Borrower? A securitized loan will mean that the borrower’s relationship with the lender can no longer be leveraged if there is something that needs to be negotiated outside of the loan documents during the term of the loan.
Property Management: Does lender have right to approve the property manager or receive notification of a change?

Exhibits

Reporting Requirements: [detailed summary of reporting requirements that managing member will be required to deliver to both members]
Annual Budget: [first year budget; will include monthly cash flow statement; sometimes includes both stub year and next calendar year]
Form of Draw Request: [for reserves and impounds]
Insurance Requirements: [detailed list of insurance requirements]