Why Lenders Should Stop Re Trading Borrowers
Published 09-21-2018
After working in both commercial real estate lending and investing for the past ten years, I can say two things with absolute certainty concerning commercial real estate loans: 1) Lenders re-trade Borrowers far more often than they should on the loan terms they put out on their initial term sheet 2) there’s almost nothing that angers a Borrower more than being re-traded (or worse having their loan denied) because an underwriting item wasn’t taken into consideration on the front end. Any experienced commercial real estate investor has probably had this happen to them at least once, if not multiple times. It can end up costing the Borrower a lot of wasted time, money, and energy, and can make the entire industry look shady*; while working in commercial lending, I personally spent half of my initial conversations with Borrowers trying to convince them that I was actually working in their best interest. It was extremely exhausting and I’m calling the industry out on it–it’s high time we clean this process up.
This is how the re-trade cycle generally works:
The Borrower submits limited financials to a Lender (sometimes as little as a year’s worth of operating statements and a summary rent roll);
The Lender’s origination representative does a cursory review of the supplied financial statements, which are typically borrower-prepared;
The Lender puts out a term sheet or letter of intent (LOI) based on the limited information they have received from the Borrower (many times the most aggressive terms the originator can argue for), with some form of clause at the end stating that they don’t actually have to lend at those terms and that more diligence is needed;
The Borrower signs up with the Lender because of the great terms they were just offered;
At some point during the due diligence process, something is “discovered” which changes the risk profile of the loan and therefore justifies a rate increase;
The Lender has spent several weeks to months working on the loan in preparation for closing and spent all of the Borrower’s due diligence deposit, so the Borrower is stuck closing at the higher rate (or shorter amortization, shorter term, or whatever other less desirable item the lender is now offering) unless the Borrower wants to start the process all over again with a new Lender.
Now tell me that doesn’t sound about as fun as being dragged through a pile of broken glass.
In order to fix this broken system, we have to look at why this is such a common practice among lending institutions and why it’s actually beneficial for them to stop. So let’s start with the first part of the process: Why do loan re-trades happen so often in the commercial real estate lending sector? In my experience, this happens for a few disparate reasons:
1) A “newbie” is working on the transaction that isn’t familiar with underwriting standards and/or the commercial loan process, so they make some an error on the terms in the term sheet. This usually happens due to lack of oversight.
2) An experienced commercial originator is going off of the limited information they are required to collect from the borrower and basing terms on a “best case scenario” because it makes them more competitive.
3) The lending representative is not clear with the Borrower about how the Lender’s interest rates are calculated or the reasons terms could change between the issuance of the term sheet and closing, then disaster strikes. Maybe the treasury yields change, bond investor demands change (driving up spreads), or a third party report comes back wonky. It happens to the even the best Lenders, but the Borrower should know about these risks before signing up.
4) An experienced commercial lender puts out a term sheet with terms they know will definitely or very likely be re-traded during the diligence process, but just wants to sign the deal up rather than losing it to a competitor—what I like to call the “bait-and-switch.” This happens WAY more than it should, particularly among certain lenders that have higher diligence deposits because the cost to start over is greater for the Borrower (i.e. Fannie Mae, Freddie Mac, CMBS, or private lenders).**
So now that we know why it happens, why should Lenders put practices in place that stop this from happening? The reasons are many, but here are my top three:
1) Using the “bait-and-switch” technique starts to look an awful lot like false advertising and fraudulent misrepresentation. Cue the class-action lawsuits.
2) Most commercial real estate investors are not one-time Borrowers, they are potential repeat clients. Being transparent about the underwriting process and what to expect (then following through) builds trust with the Borrower, so you could end up with a lifetime customer for not only future loans, but perhaps even other banking products. It’s much easier to keep a current client than find a new one.
3) Reputation is a funny thing. It takes a lifetime to build but only a second to ruin. Don’t ruin your financial institution’s reputation with bad lending practices. Remember that one bank that signed up a bunch of customers for credit cards they didn’t know existed? Every department in the bank (even unrelated) is still feeling the pain from that.
In order for Lenders and Borrowers to have smooth loan transactions, I propose some tips to keep everyone on the same page:
Tips for Lenders:
Make term sheets or LOIs Borrower-friendly and easy to understand; don’t use industry jargon that the average person won’t understand.
Pair new commercial lenders in your institution with experienced underwriters and make sure term sheets are reviewed by a more senior lender, underwriter, or credit manager before they go out.
Be clear with the Borrower about how your institution calculates interest rates (i.e. index + spread) and what may cause the interest rate to change before closing; offer an interest rate lock if it is available.
Make sure the underwriting is sufficiently completed to put forth a realistic term sheet, letter of interest, or loan application.
Look for CapEx, one-time, or non-recurring expenses in financials statements; make sure to ask the Borrower if there are any that have been included into one of the regular expenses (i.e. repairs, maintenance).
Review leases for anything that could impact underwriting cash flow (i.e. lease roll, amendments, free rent, tenant improvements, or concessions).
Check rent roll for any tenants that could cause possible environmental contamination (i.e. on-site dry cleaners, auto repair shops, gas stations, or restaurants); if any of these types of tenants exist, ask the Borrower (or owner) if they have a phase II environmental engineering report to review.
Before pulling credit, ask the principals if the Borrower, sponsors, or any of their businesses have credit issues including bankruptcy, foreclosures, short-sales, charge-offs, judgments, or liens. Also ask if they know their approximate current credit score.
If the property is a purchase rather than a refinance, check to see if new ownership triggers a property re-appraisal and potential property tax adjustment (this is very common in California and many other states and the difference can be significant).
Get a CapEx Schedule showing property improvements and renovations over the last 5 years and ask the Borrower if there are any schedule or anticipated expenditures over the next couple of years.
Make sure to check area cap rates to get a realistic approximation of the property’s value rather than relying on the Borrower’s “guesstimate.”
Know what types of loans/products your institution is favoring (or has suspended) and learn to recognize any credit manager bias for/against specific areas or property types (i.e. what is and is not getting approved at your financial institution).
If one diligence item (i.e. seismic zoning, environmental contamination, etc.) needs to be checked to know if your institution can proceed, order that one report (maybe on an expedited basis) and don’t spend the rest of the deposits unnecessarily unless timing to closing is an issue.
Set realistic timelines for the Borrower and follow up regularly to give updates on the process.
Tips for Borrowers
Be honest—if you know there’s a problem and you disclose it on the front end, the lender may be able to find a way to work around it. If you don’t and the lender discovers the problem during the diligence process, it becomes a character issue that may result in an immediate denial of the loan without trying to find a work-around. To be clear, this means:
disclosing any potential credit issues (i.e. bankruptcy, foreclosure, short-sale, charge-offs, judgments, or liens);
disclosing any property or tenant issues (i.e. non-payment, notice to vacate, environmental contamination, etc.);
disclosing and liens on the property or pending or threatened litigation;
disclosing any other material item that could impact your credit approval.
Prepare a full loan package to deliver to the lender; it makes their job easier and enables them to see if there are any potential issues up-front. If you have any past or current credit issues, write a letter of explanation to submit with the loan package. If there are any one-time or CapEx expenditures in your financial statements, make sure they are clearly labeled so they aren’t included in your cash flow analysis.
Once the letter of interest, term sheet, or loan application has been given to you, ask if the underwriting has been substantially completed (except third party reports) and if they are confident that the terms won’t change assuming acceptable third-party reports.
Ask what they are estimating your NOI, LTV, DSCR, and debt yield to be and how they arrived at those numbers; sometimes errors occur in NOI calculations, which could result in your rate being higher than it needs to be.
Ask if the rate is locked until closing and if not, if a rate lock option is available (and at what price).
If the rate cannot be locked (or is too expensive to lock), make sure to ask what could trigger an interest rate increase (i.e. LTV, DSCR, debt yield, index move, spread change, etc.)
If possible, get a broker opinion of value (BOV) on your property, understanding that these estimates are usually higher than what an appraisal may come back at. Also check local area cap rates to get an idea of how that may be applied to your property’s value.
Know that there are some things that are beyond a lender’s control (i.e. appraisals and other third party reports, treasury yields, and spread changes) that may affect your interest rate and prepare yourself for that possibility.
*Please note that although I use the terms “lenders” and “industry” somewhat liberally in this article, not all lenders or industry representatives will automatically end up re-trading you. There are plenty of good, honest people out there that do their job properly, it just feels like it’s hard to find them sometimes.
