EM Law | Commercial Lawyers in Central London
What is commercial property financing?
Commercial property financing is where a borrower either borrows money to invest in income-generating real estate or raises finance from real estate (also referred to as property). Usually, the money borrowed will be secured on the property and will be used by the borrower for one of the following purposes:
- To buy the property.
- To invest in its business.
- To refinance existing borrowings incurred for one of the above purposes.
There are two main types of lending in commercial property financing:
- Investment finance. This involves the lender financing an existing property (that is, one that has already been built) with existing tenants.
- Development finance. This involves the lender financing the purchase and building of the property concerned, either on a pre-let or speculative basis.
This note focuses on investment finance.
A commercial property finance lender will be particularly interested in:
- The cashflow generated by the property (that is, the rental income) that will be used to pay interest on the loan; and
- The value of the property as compared to the loan amount, as selling the property or refinancing the loan against the property is likely to be how the loan will be repaid.
Key documents in a commercial property financing
The documents commonly used in real estate finance transactions are set out below.
If the loan is syndicated, the Loan Market Association (LMA) form of facility agreement for commercial real estate finance multi-property investment transactions may be used. Alternatively, the facility agreement may be based on the particular lender’s in-house standard form or a bespoke facility agreement developed over time with its external lawyers.
In almost all instances a facility agreement will be preceded by a term sheet or heads of terms, setting out the main terms of the funding in advance of formal documentation.
The terms of the documents, particularly the facility agreement, may also be influenced by the lender’s plans for the debt.
The facility agreement will contain the customary conditions precedent relating to constitutional documents and approval of documents, adapted as appropriate if the borrower is not a company incorporated in England and Wales. Additionally, there will be property-related conditions precedent.
In addition to the covenants (or undertakings) contained in a secured facility agreement for general corporate purposes, a real estate finance facility agreement will contain specific property-related covenants. These are designed to ensure that the property does not change fundamentally during the life of the facility (that is, change in a way that would reduce its value or create a liability for the borrower that would lead to it not being able to repay the loan or interest on the loan).
The financial covenants create an early warning system that lets the lender act proactively to prevent a default. The lender can assume greater control when there are signs that the borrower may become incapable of servicing the loan, or the security for the loan may be inadequate to ensure that the loan is repaid in full.
As well as the representations contained in a typical facility agreement (for example, as to the borrower’s existence and capacity to enter into the finance documents), the lender will usually require the borrower to give certain property-related representations. Sometimes, these will be included in the security documents instead.
Interest payment dates
Rent on commercial premises is usually paid quarterly on the traditional quarter days (that is, 25 March, 24 June, 29 September and 25 December). As rent is used to pay the interest on the loan, interest payment dates for a real estate finance loan will often be fixed rather than being selected by the borrower via an interest period selection mechanism. The interest payment dates are often fixed at quarterly intervals a couple of weeks after the quarter days to allow the borrower time to chase up any late paying tenants.
The precise security the lender takes from the borrower will vary depending on the type of borrower and the transaction structure.
Charge over borrower’s shares
Under this document, the parent will grant the lender a charge over the borrower’s entire issued share capital. This enables the lender to realise its security over the property by selling the shares in the borrower. This enforcement method may have tax advantages over selling the property itself.
The lender is unlikely to lend the borrower the entirety of the property’s purchase price, so the parent (or other sponsor behind the property investment) will usually provide the balance to the borrower by way of subordinated shareholder loan or equity.
Real estate finance loans are often made available on the basis of a floating interest rate referenced to LIBOR but with a requirement for the borrower to hedge the interest payments on a certain percentage of the principal amount of the loan. By entering into interest rate hedging documents, the borrower reduces the risk of it being unable to pay interest on the loan because of an increase in LIBOR.
Management agreement and duty of care agreement
If the property is let to multiple tenants, the borrower may appoint a managing agent under a management agreement to collect and administer the rent and service charge and generally deal with managing the property. The lender will want to review the management agreement to ensure that the managing agent’s obligations (in particular, in relation to rent collection) are adequate and that the managing agent is required to have suitable professional indemnity insurance.
If the property being financed is leasehold, the lender will need to check the headlease to ensure that it will provide adequate security for the loan.
Usually, the lender will have little interest in the acquisition agreement under which the borrower buys the property since it will usually contain limited express warranties from the seller. Instead, the lender will rely on any certificate of title or report on title. However, if this due diligence discloses issues that cannot be addressed by further due diligence, and can only be remedied contractually, the borrower may obtain contractual remedies in the acquisition agreement.
Key features of security package in commercial property financing
The key elements of the lender’s security package are likely to be the charge over the borrower’s shares and the debenture from the borrower. Notable features of the security taken over the borrower’s assets are explained below.
Security over the property will be a major part of the lender’s security package. Usually, the lender will take a legal mortgage.
Where the property is let, the lender will want to monitor the flow of rent and ensure that rent is used to service the loan.
Usually, the lender will take security over the borrower’s various bank accounts, including the one into which rent is to be paid.
The lender should take security over the insurance policy relating to the property (except where a leasehold property is insured by the landlord) or the proceeds from that policy. The security will usually be by way of assignment. If the security is intended to be a legal assignment of the insurance policy, the whole policy must be assigned (which may be problematic where the policy is a block policy) and a notice of assignment will need to be given to the insurer.
If the borrower has entered into any key agreements relating to the property or the loan, the lender may wish to take an assignment of these as part of its security package.
For any questions you may have concerning commercial property financing contact James Williamson.