With the recent turbulence in capital markets and tightening of available financing, buyers of commercial real estate should focus on loan contingencies in their purchase and sale contracts. Most contracts include a feasibility period, during which time the buyer can inspect the property. If the property is not acceptable, the buyer can terminate the contract before the feasibility period ends, and get his earnest money deposit back. Until recently, with more buyers than available properties and easy credit, sellers have not been receptive to separate financing contingencies. Buyers were required to satisfy themselves of their ability to obtain any necessary loans during the feasibility period. Now, with less available financing, tighter loan underwriting, and fewer qualified buyers, sellers may need to reconsider.
Buyers should still be expected to obtain a loan commitment from a lender during the feasibility period. Lender commitments typically include an agreement to loan an amount of money at an interest rate based on a set formula, with closing conditions. Traditionally, these conditions were, for the most part, in the buyer's control and did not often lead to issues affecting the loan closing. To minimize the risk of rate increases under the set formula, many lenders also permit the buyer to lock a fixed interest rate prior to closing, if the buyer agrees to compensate the lender for certain risks if the loan does not close. With readily available debt financing, buyers could typically obtain a loan commitment during the feasibility period, lock in an interest rate, and encounter minimal surprises prior to closing.
With the recent credit crunch, commercial real estate lenders are carefully reviewing new loans. For buyers, this many lead to higher interest rates, greater scrutiny of the appraised value of the property, lower loan-to-value ratios (which require larger buyer down payments and lower loan amounts), higher tenant occupancy requirements, and higher debt service coverage ratios (based on the monthly property income and loan expenses). Buyers must also be aware of failed loan commitment conditions outside of their control, such as tenant defaults prior to closing that decrease the occupancy rate of the property, and which may lead to a decreased loan amount. Finally, lawsuits have arisen from time to time when lenders do not fund loans pursuant to commitment agreements with buyers. It remains to be seen whether these types of lawsuits will increase as a result of lenders making decisions in rapidly changing capital markets. However, the possibility of lenders failing to fund their commitments is an added risk for buyers given the dynamics of current capital markets.
As financing commercial real estate becomes more difficult and the number of qualified buyers decreases, sellers may be more willing to negotiate loan contingencies. One approach is for the buyer to agree to use good-faith efforts to obtain a loan commitment during the feasibility period, and, if successful, to deliver a copy of the lender's commitment letter to the seller. If the lender does not fund the loan at closing in the same amount and at the same rate agreed upon in the commitment (other than because of a buyer default under the commitment), or if the loan amount decreases or the interest rate increases due to factors beyond the buyer's control, then the buyer would have the right to terminate the purchase and sale contract and receive his earnest money deposit back. These alternatives for a buyer are almost certainly better than the prospect of bringing a lawsuit against a lender for breach of a commitment. There are likely to be conflicting facts and perspectives in such a lawsuit, several years of litigation, and an uncertain outcome.
In the recent past, most sellers would not agree to a buyer financing contingency that lasted until closing. This may give a buyer who changes his mind too easily a way to get out of the contract. However, most buyers sink considerable money into their feasibility period investigations of the property, and are not looking for a pretext to terminate the contract. They also do not want to forfeit their earnest money deposit through no fault of their own. If lenders are making decisions based on events outside the control of the buyer, it may be appropriate for sellers to share some of the resulting financing risk.
In reality, these risks are probably low, and a seller's willingness to work with a buyer may lead to a contract that a qualified buyer might otherwise sign with a different seller for a different property.
Andrew S. Gabriel is a partner with McDonald Carano Wilson and chairman of the firm's statewide corporate law practice group. He practices primarily in the areas of commercial real estate and corporate transactions.
