Option Terms

Option Terms in Commercial Mortgages

Option terms refer to specific clauses within a commercial mortgage agreement that grant either the borrower or the lender the right, but not the legal obligation, to execute certain actions or modify the loan structure at a future date. These terms are predefined during the underwriting process and provide a layer of flexibility to address changes in market conditions, property performance, or the strategic goals of the parties involved.

Unlike standard loan obligations, which are mandatory requirements, option terms are elective. They are typically contingent upon certain conditions being met—such as the property achieving a specific Debt Service Coverage Ratio (DSCR) or the payment of an "extension fee." These terms are critical in commercial real estate finance because they allow for the management of interest rate risk and liquidity over the life of a long-term asset.

Common Types of Option Terms

In most commercial lending environments, option terms fall into several distinct categories:

• Extension Options: This is perhaps the most common option term, allowing a borrower to extend the maturity date of the loan (often by 12 to 24 months) after the initial term expires. This is particularly useful in "bridge-to-permanent" financing where the borrower needs more time to stabilize a property before seeking long-term debt.
• Conversion Options: These allow a borrower to convert a loan from a floating interest rate to a fixed interest rate (or vice versa) during a specific window of time. This protects the borrower against volatility in the benchmark rates, such as SOFR.
• Call Options: A lender-side option that gives the bank the right to "call" the loan due and payable in full before the stated maturity date. While less common in standard commercial loans, they are found in some private equity or high-risk debt structures.
• Prepayment Options: These clauses define the borrower's right to pay off the mortgage balance early. While many commercial loans include yield maintenance or defeasance penalties, a prepayment option may specify "open windows" where the borrower can exit the loan without penalty.
• Future Advance Options: Also known as "delayed draw" features, these allow the borrower to request additional capital from the lender at a later date, usually to fund capital expenditures (CapEx) or tenant improvements as new leases are signed.

The Impact of Option Terms on Loan Pricing

Option terms are rarely granted without a cost. Because they represent a potential shift in risk from one party to another, they are factored into the loan pricing. For instance, a loan with three one-year extension options will likely carry a higher interest rate or higher closing fees than a loan with a hard maturity date.

Lenders view these options as contingent liabilities. If a borrower exercises an extension option when market interest rates have risen, the lender is forced to keep their capital deployed at a potentially below-market rate. Consequently, exercising these options usually requires the borrower to be in "good standing," meaning they have no active defaults and are current on all financial covenants.