Borrowers tend to review loan documents, if any, shortly before closing. But property developers (and their attorneys) should discuss key loan terms with their lender much earlier, especially if the developer is raising money from investors. Promoters need to ensure that the terms of the loan will not prevent them from fulfilling the promises made to investors.
Commercial real estate developers use many profit-sharing schemes to attract investors. The formula chosen for the distribution of profits, also called “distribution”, is described in the organizational documents of the borrower – generally, the operating agreement of an LLC, and binds the promoter. Without favorable distribution terms, promoters will not have investors.
However, lenders who provide loans for real estate development want to secure their loan with future cash flows from the project. Lenders do not want a borrower to siphon off all the profits from the project and pay 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 intended to pay management fees.
Lender restrictions on a borrower’s ability to make distributions are common, but there are solutions that balance the lender’s need to secure their loan with the sponsor’s need to periodically distribute profits to investors. For example, covenants prohibiting distributions can be lifted once the borrower achieves an acceptable loan-to-value ratio, once a new development stabilizes and achieves a sufficiently high debt service coverage ratio, or when it reaches other financial milestones.
Other loan terms that borrowers should consider are change of control clauses that require the borrower to maintain its current ownership and management structure. Changes in ownership or management of the borrower, whether voluntary or involuntary (for example, death or divorce), can trigger a loan technical default. These terms should be discussed by the borrower with the lender during loan negotiations.
Early in the fundraising process, promoters need to anticipate lender requirements and ensure they are able to deliver on 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.