Last week, in their latest FinFacts newsletter, George Smith Partners released the following tombstone:
"George Smith Partners successfully placed $14,050,000 in construction financing, which funded 89% of total project cost, for the acquisition and reposition of a 79-unit, mixed-use property in a desirable and historic St. Louis City neighborhood. GSP was engaged by the Borrower when its original lender, a national REIT, was forced to re-trade the Borrower on loan terms due to the COVID-19 pandemic."
What does it mean to "re-trade the Borrower on loan terms"?
According to Wikipedia, a re-trade is the practice of renegotiating the purchase price of real property by the buyer, after initially agreeing to purchase at a higher price. Typically this occurs after the buyer gets the property under contract and during the period that it is performing due diligence. The buyer may raise a due diligence issue and demand a purchase price adjustment to a lower re-trade price.
In a context of commercial real estate finance, to re-trade the borrower means to alter the loan terms negatively, usually due to some serious economic event, such as the Great Recession or the COVID Crisis.
Many conduit loan borrowers, when the Great Recession hit in mid-2008, were caught with their loans still in process. The conduit lenders went back to their borrowers and told them, "Look, the market for commercial mortgage-backed securities is collapsing. We can't sell your loan at our originally proposed interest rate. We are going to have to raise your interest rate by almost 1% and cut you loan-to-value ratio back from 75% to just 62%." More of these conduit borrowers chose to walk.
The re-trade of the big construction loan that George Smith Partners described above was probably a big cut in the loan-to-cost ratio. You will recall that the Total Cost of a construction project is the sum of the land cost, the hard costs, the soft costs, and a contingency reserve of around 5% of hard and soft costs.
The Loan-to-Cost Ratio is therefore just the Construction Loan divided by the Total Cost, multiplied by 100%. The most typical loan-to-cost ratio on construction loans is 80%.
Let's now go back to the big construction loan that George Smith Partners just closed. Perhaps the REIT initially proposed a construction loan of 80% of cost; but after COVID became a pandemic, this REIT probably cut heir loan-to-cost ratio down to only 70%.
The developer probably didn't have an extra $1.6 million in equity to contribute to the project. Fortunately, the good folks at George Smith Partners saved the day.
Can lenders really re-trade a borrower legally? You will recall that in commercial real estate finance ("CREF"), lenders almost never issue a firm commitment. They merely issue a term sheet - also known as a loan proposal or conditional commitment letter.
A term sheet is not a firm commitment. It is just a letter expressing an interest in making a commercial loan and providing a good faith estimate of the eventual terms.
Although the typical term sheet is not binding on a commercial lender, it is the custom and practice in the industry for the lender to honor a term sheet, absent a major change in the bond and/or real estate markets.
In real life, the vast majority commercial lenders are pretty good at sticking to the terms of a term sheet.
Mini-Lessons this week:
Burn-off's, par passou notes, A/B notes