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When Borrowers Don’t Perform

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This article was originally published in 2014; however, it is as relevant today as it was then. It offers an insider look at how lenders view borrowers who apply for commercial real estate loans that they cannot support.

If you are currently applying for a commercial real estate loan, you might not want to know what other brokers and lenders are saying about you. Or maybe you do…

Are Private Lenders Real?

Our company often gets inquiries from prospective borrowers who are unfamiliar with private commercial lending. They almost always ask us, in one way or another, “How do I know your lenders are real?” “How do I know they are going to perform?”

In private banking, private finance and private lending, there are protocols. Protocol is a fancy word for politeness. There is an order and method to doing things. The protocol is designed to protect the lender/source of funds from fraudulent borrowers, and believe me, there are plenty of scams, rip-offs and other con artists posing as project principals or borrowers who are actually seeking to get private sources to give them some of their money without actually having a real project to invest in. Hence the concept of due diligence on the part of the lender/funding source.

So in reality, both sides are checking the other side out. Like any process of getting to know someone, there are steps and stages. First step is always an introduction. If there is a broker involved, the broker’s job is to vet both the borrower and the lender before making the introduction and to their best ability determine that both sides are who they represent themselves to be.  Usually there is a mutual confidentiality signed in advance of a formal introduction to assure everyone’s privacy and the confidentiality of data and other information that will be exchanged.

How to Engage with Private Lending

In order to facilitate the project introduction, the broker may use a loan intake form to collect basic information about the borrower and the property. The lender will sometimes use their own loan application and may also request property financials, personal financials, and other property-related information. At this phase, everything is stated, meaning that the borrower represents who he/she is and what the current performance of the property is. During the course of underwriting, or due diligence, the borrower will be asked to “prove” everything they have stated on the loan application.

Based on the preliminary information, the lender will determine initial interest in making the loan. If there is no interest, you will be told so quickly. If there is interest, the lender will issue a Letter of Intent (aka Letter of Interest or Term Sheet) indicating proposed terms and conditions to close the loan.

Why Private Lenders Issue LOIs

Unlike bank lending, where the loan is backed by depositor’s funds; in private lending, the funds are coming from the lender directly, and therefore must be earmarked in advance of funding to assure liquidity when the loan funds.

When a lender does offer an LOI, they are essentially saying two things: i) they are stating the proposed terms under which they will fund the loan; and ii) they are making sure the borrower is prepared to meet all of the conditions to fund and essentially perform on their obligations.

Conditions to Close

Usually, conditions to close include such items as full financial and economic review of the proposed collateral and of the borrower.  What this means is that everything that was stated on the loan application is now going to have to be proven by independent third-party means. For example, if a borrower has provided his/her financial statement, this will now be backed by bank statements, stock statements, copies of insurance policies, deeds to property, copies of mortgage documents, tax returns, etc. The burden is now on the borrower to provide evidence that the property and the borrowing entity are who and what they say they are, and that there will be no surprises after the loan closes.

Some conditions require third-party reports such as an appraisal, a phase one environmental report, or a market feasibility study. Even though the lender orders these reports, and they “belong” to the lender, it is still the borrower’s responsibility to have independent parties confirm the information that was initially provided on the loan application. In other words, if an appraisal comes up short of the value the borrower claims, the lender can cancel the deal because the value was not confirmed.

Another area of responsibility for the borrower is to provide all of the deposits and fees that the lender requires in order to complete the due diligence phase of underwriting. Lenders charge fees to cover hard costs that they must incur on behalf of the borrower, and also to ensure that the borrower is committed to closing the loan with this lender.

What the Borrower is Responsible For

When a borrower signs and accepts an LOI or Term Sheet, he/she is agreeing to perform according to the contract they are signing. This means performing in terms of providing timely payment for the necessary expenses AND providing supporting documents and reports within the timeframe required by the lender.

If the borrower does not perform, most agreements have clauses describing the remedy to the lender. In real estate transactions, there are two types of possible remedies—specific performance or liquidated damages. A liquidated damages clause is more common—stating that if the borrower fails to perform within the agreed-upon timeframe, they will forfeit any and all fees paid to date and that will be the extent of damages the lender can collect from them. Specific performance, on the other hand allows the lender to then seek remedy from the borrower for any and all hardship they may have endured, including their time and the amount of interest they could have made on their money if they had invested it instead of allocating it to this loan that has failed to close.

What Happens When Something Goes Wrong

 I’m amazed at the number of times I’ve seen a borrower sign an LOI, pay a fee or deposit and then fail to perform on the documentation and demand all of their money back! I’ve seen borrowers ignore deadlines and expect lenders to extend the loan commitment indefinitely without penalty to the borrower. I’ve seen borrowers sign commitment letters and then fail to wire funds. I’ve seen borrowers be unable to substantiate significant amounts of the information they put down on their loan applications. I’ve seen appraisals come up significantly short of the value represented by the borrower.

What’s amazing to me, and to almost every other broker I’ve ever worked with, is that almost invariably, when the borrower fails to perform, they try to make it the lender’s fault. Come on folks, let’s be adults here. If you’re going to apply for private commercial funding, please understand what the “rules” are. If you agree to play by the rules, and you represent your project accurately to the best of your ability from the get go, you will get funded. There’s no need to overinflate the numbers, misrepresent your capability or otherwise fail to perform. If you project is fundable, then it should be strong enough to stand on its own merits without you trying to make it look better than it is.

There’s a loan program for almost every fundable deal. As a broker, our job is to match you with the right one. Like the line in Jerry Maguire,

” Help us help you!”

CONTACT Sofia Capital Ventures for assistance on your next deal.