September 23, 2019

How Obscure Loan Terms Could Cost You Millions

It’s the biggest no-call of all time. This one play that went unseen meant that the New Orleans Saints sat home in 2019 while the Los Angeles Rams went to the Super Bowl… but what’s that got to do with your loan? It’s a perfect example of how much of an impact what you don’t see can have upon your real estate investment.  Let’s mention just three to demonstrate how much of an impact those terms can make.

#1 – SWAP SPREAD – is the iconic “killer no-see-um”.  Borrowers will work with great diligence to negotiate a loan spread and never even realize that there is a swap spread that will also be added and which can also be negotiated. While you see the loan spread (it’s stated right in your promissory note), the swap spread is rarely even mentioned in the loan documents. Rather, it is simply included in the fixed-rate cost presented by the bank. How big of a deal can it be?  In instances when the borrower does not have a swap advisor, banks might add up to 40 or 50 basis points to the cost. On a $20 million loan with a 10-year term, that’s added bank profit of $800,000 that you will be paying over the term of the loan. It’s tantamount to the bank proposing an origination fee of $800,000, or 4 points. This swap spread can be reduced much closer to break even when using a registered CTA (Commodity Traders Advisor) like CMAC Partners.  A registered CTA knows what the swap cost should be and how to negotiate so that the borrower has transparency.

#2 – BREAK FUNDING – is a term that is now frequently used and applied along with its cousin “Yield Maintenance” in lieu of the more traditional prepayment penalties (e.g. 2% of the remaining principal balance). However, the outcomes can be very different and every buyer needs to be aware of just how the Break Funding or Yield Maintenance formula proposed in their loan document is calculated. If you are not represented, our best advice is to ask your banker to walk you through the formula and then provide you with four examples which should be attached and made a part of your loan agreement. Request examples of short-term and long-term prepayments (e.g. 2 years and 5 years), assuming a 50-basis point swing in either direction from the curve. Once you understand the potential exposure, you will be in a much better position to negotiate and decide which type of prepayment penalty works best for you.

#3 – COST OF FUNDS – is a fancy way of a bank saying that they will charge you whatever they feel is appropriate. They might as well be a car dealer selling you some agreed amount “over invoice”. Proceed with caution! Make sure that any Cost of Funds agreement contains a clearly defined benchmark in the document such as a 10-year Constant Maturity Treasuries rate, Wall Street Prime, or 30-day Libor. Once you have that benchmark and the bank’s spread from that benchmark, you will be in a position to negotiate a loan spread that meets your objectives.

These are just a few of many examples of loan terms which can be invisible to the borrower.  Best advice? Get advice!