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How To Review a Commercial Term Sheet

How To Review a Commercial Term Sheet

Todd Wheatley here from Candor Realty Boston. In this video, I’m going to break down what a commercial loan or term sheet looks like. This is a little bit different than what you would see on a residential loan, but many of our investors who are looking to expand into commercial real estate or rental properties that are larger than four units will need a commercial loan. So this is how you … I’m going to walk through an actual term sheet that I’ve used, break down each section, explain what each section is. And just keep in mind every bank has a slightly different format, but the general content is going to be the same.

Upon sending a request to your commercial bank explaining your project, typically you’ll send them a writeup on why you’re interested in the property. You should include a financial analysis, including an analysis and you can see one of our other videos on how to do those analysis, but the more you can demonstrate to the bank that you’ve taken a look at the property, you understand how it’s performing financially, and you’re explaining what your business plan is, the better off you will be.

Once you send that request to your loan officer, they will issue a term sheet. We’ll use this one from Workers Credit Union, I have a good relationship with the folks over there. They’ve issued term sheets on several projects that we’ve purchased and many that we’ve taken shots at, but haven’t purchased, so I’m very familiar with their format.

The top section is just kind of an introduction, thank you for issuing this term sheet on the property. Obviously it sets forth many conditions. This is not a commitment. This is just an intent that we will work with you to secure the loan if you were to get the property under agreement.

I’ve redacted some of the personal information that I didn’t want in the video. It’s not important for the sake of this video. Just keep in mind, you know, there’ll be additional data points, names, addresses, property address, things like that, that will be on your term sheet.

You’ll see the borrower name at the top. This typically needs to be an LLC or legal entity. You nearly certainly cannot take title or secure the loan in a personal name with a commercial bank. So you’ll want to keep that in mind. You will have guarantors. These are the individuals that are members of the LLC that will be personally guaranteeing the loan. If that’s applicable, some loans have personal guarantees and some don’t. And as you can see, some are unlimited and some are unconditional. That will be up to your relationship with the bank and your experience. But these are the people that are personally guaranteeing the loan if you were to default.

The next section, we have loan amount. In this particular example, it’s 75% of the purchase price, or the as is appraised value. That can vary. That can sometimes be 70%, 75%. We actually got this term sheet revised up to 80%. So keep in mind that that loan to cost or loan to value will change depending on your conversation or relationship with your loan officer. But this will explain the loan amount.

The purpose. What is the mortgage going to be used war? What is the loan going to be used for? In our case, it was a specific property. And then you see kind of a general source and use of funds explaining how much the borrower needs to bring, $542,000, how much the bank will bring in a mortgage, $1,575,000. And then you’ll see on the right hand side, purchase price, purchase price, origination fee, and estimated closing costs, just outlining kind of where all the funds will need to come from and what they will be used for.

Then we get into the specifics of the actual mortgage. And again, this will vary depending on the bank, what their appetite for loans are on your asset type, and what your relationship and experience is with that bank.

In this particular example, this is a 10 year loan. Typically commercial loans will be five, seven, or 10 years. That’s a generality, but those are kind of the three most common lengths.

The interest rate will be fixed for a period of five years at 4%, and then it’s adjustable and they explain the adjustable nature of it in the next paragraph, they explain what index or rate you will be adjusted on beginning in this particular term sheet in that sixth year, so you can see the interest rate shall reset at 2.5% over the applicable index and then they tell you which index. So depending on what interest rates do in five years, this 4% fixed rate for the first five years might be great, but this could very quickly go up if the underlying indexes have moved up in the first five years.

This is a major difference between commercial loans and residential loans. Typically residential loans will be fixed for 15, 20, 25, or 30 years, unless you use an adjustable rate mortgage, but most commonly it’s fixed rate. With commercial loans, it’s usually fixed for a period of time and then it’s adjustable after that period. Very much pay attention to this, and very much do your own research and analysis on where you think interest rates will go in the future and how that would impact the performance of the subject property.

They explain how interest will be calculated on an actual 30/360 basis. This is just an accounting methodology. It doesn’t make a huge difference, but you’ll want to understand that. Amortization. Although it’s a 10 year note, it is amortized over 30 years. To me, that’s very attractive because it helps keep my debt service relatively low. If it were to be amortized 10 or 15 or 20 years, the debt service on a monthly basis would be much higher. This is a very attractive loan product to me, 10 years in length and 30 year amortization.

Then they explain the payments. The initial monthly principle and interest payments are to be this amount. That’s pretty straightforward. Collateral, this is where they explain, and again, these are for real estate assets, so they explain that they will take a first position loan on the subject property. In the event that you were to default, they would foreclose on the property and take possession.

Origination fees. Again, this is very different than residential loans. Origination fees, or points, as they’re often called, are applied to … These are fees as a percentage of the overall loan amount that you pay, typically, at closing. In certain circumstances, you pay at the backside of the project, but if it’s a rental property or a long term project, it’s typically paid at closing.

I’ve done the math here, so 0.5% of the loan amount is $7,875. And again, you would see this on the settlement statement as a closing cost when you close on the property. This can range. 0.5% is very attractive for a commercial bank. I’ve seen 1%, 1.5%, and even up to 2% or higher with hard money or non-commercial banks.

Prepayment penalty is none. To me, this is very important given I may want to hold the property for 10 years, but I may get an offer I can’t refuse just two or three years in. The market’s moving very quickly. I do not like prepayment penalties if at all possible, and so this explains that there is not one on this term sheet.

Good faith deposits. These are typically upon signing the term sheet, you would send in good faith deposit. This is used to pay for things like the appraisal and underwriting fees. This fund, this money, anything that’s left over is applied towards your closing costs or is refundable if you ultimately do not close on the property minus any of the costs that you’ve already spent. For example, this is a $5,000 good faith deposit, if the appraisal costs $3,000 and you didn’t close, you’d get $2,000 back. And again, have that conversation with your loan officer to make sure you understand what this deposit is.

Financial covenants. This explains that the bank expects the property to perform at a certain debt service coverage level. We’re not going to cover debt service coverage in this particular video, I’ll do a separate video on that, but they do expect most banks are in a 1.2 to 1.3x range, meaning that the cash flow more than covers the debt service on the property, and basically this helps the bank understand that the debt service will be taken care of from the property itself and that the borrower doesn’t need to inject additional capital into the project just to cover the debt service.

Loaned value. Again, this was a 75% LTV term sheet. This just explains that. Again, this can change depending on your specific situation. Legal documentation is pretty self explanatory. Environmental assessments explains any additional documents or questionnaires that you might need to complete along with this term sheet, very standard.

Financial reporting. Each year, borrowers typically will need to send in their tax returns and other property specific financials, things like rent rolls, P&L, and other financials to the bank for review to ensure that the property’s in good standing and being run to plan. Make sure you understand these requirements and expectations prior to signing the term sheet.

Membership. This is typical. Typically commercial banks will want you to open operating accounts, checking, savings accounts with the bank and run the finances for the property from that bank. You can have a conversation with the bank if you already have a deposit banking relationship, if not, you just want to make sure you fully understand this and how it may impact your processes for paying bills, paying mortgages, and paying other expenses related to your properties.

And again, just some additional covenants here. No junior mortgages, they don’t want to see additional … They have a first position lien on the property. They don’t want to see junior or second position liens. That’s very straightforward and common. Just some additional language that you’ll want to read, just to make sure you understand what you need to submit to the bank, what they’ll be reviewing during underwriting, and what you should expect. And that is it.

Really, it’s just a term sheet, term letter outlining the arrangement. If you are in agreement with it, you would sign it down the bottom, down here, both as a guarantor and as the borrower, which is typically the manager or one of the members of your LLC, depending on your entity setup. And that’s it.

Hopefully that was helpful. If you have any questions, drop a comment down below, or reach out to me directly, and I’ll be happy to talk through this more specifically with you or review a term sheet if you have one. All right, have a nice day.

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