Borrowers tend to review loan documents, if at all, shortly before closing. But real estate developers (and their attorneys) should discuss key terms of the loan with their lender much earlier, especially if the developer is raising money from investors. Developers should ensure the terms of the loan will not prohibit them from fulfilling promises made to investors.
Commercial real estate developers use many different profit-sharing formulas to attract investors. The chosen formula for distributing profits, also referred to as the “distribution,” is described in the borrower’s organizational documents – commonly, an LLC’s operating agreement, and is binding on the developer. Without favorable distribution terms, developers will not have investors.
However, lenders making loans for real estate development want to secure their loan with the project’s future cash flow. Lenders don’t want a borrower to siphon off all profits from the project by paying them out to its owners/investors. Therefore, commercial real estate loan agreements typically include restrictions on the borrower’s ability to make distributions, and these restrictions may contravene what the borrower promised its investors, or what the developer planned to pay themselves in management fees.
Lender restrictions on a borrower’s ability to make distributions are common, but there are solutions available that balance the lender’s need to secure its loan with a developer’s need to periodically distribute profits to investors. For example, covenants prohibiting distributions may be lifted once the borrower achieves an acceptably low loan-to-value ratio, once a new development stabilizes and achieves an acceptably high debt service coverage ratio, or upon reaching other financial milestones.
Other loan terms borrowers should consider are change in control covenants that require the borrower to maintain its current ownership and management structure. Changes in ownership or management of the borrower, whether voluntary or involuntary (e.g., death or divorce), may trigger a technical loan default. These terms should be addressed by the borrower with the lender during the loan negotiations.
Early in the fundraising process, developers should anticipate lenders’ requirements and ensure they’re able to fulfill their promises to investors. Developers who have open and clear communication with lenders, well in advance of closing, can avoid surprises in the loan agreement that delay closing or require renegotiation with their investors.
* This article first appeared in The Journal Record on August 4, 2022, and is reproduced with permission from the publisher.