Most lenders are content with traditional fixed- or variable-rate interest on their loans. But some offer “participating loans” for more highly leveraged projects.
Will Rogers supposedly said, “Don’t wait to buy real estate. Buy real estate and wait.” This witticism reflects the tendency of real estate values to appreciate over the long-term.
Most lenders are content with traditional fixed- or variable-rate interest on their loans. Meanwhile, their borrowers keep cash flow and real estate appreciation for themselves. But for more highly leveraged projects, some lenders offer “participating loans,” where borrowers pay additional interest tied to cash flow or appreciation. For their own part, borrowers usually expect lower fixed or variable interest rates on participating loans.
Additional interest tied to cash flow is paid periodically, based on project revenues less expenses. In these situations, lenders want all rents and other revenues to be accounted for, with expenses minimized. When lenders also participate in project appreciation, they typically require borrowers to fund reserves for capital replacements. Payments into reserves are deducted from cash flow. Borrowers are expected to annually furnish operating budgets and audited financial statements, so lenders can predict and verify their share of cash flow. Lenders also sometimes insist upon preferential payments of additional interest on cash flow, tied to a minimum rate of return on their investments.
The Lender’s Perspective
When lenders participate in project appreciation, three events trigger borrower obligations to pay additional interest: sales of projects, major casualties or eminent domain takings that generate insurance proceeds or condemnation awards and loan repayments. All these scenarios present a potential problem for lenders; namely, what happens if the triggering event occurs before the project is stabilized and the lender realizes its expected investment return?
Consider a situation where the lender finances major construction, and the triggering event occurs before project completion and lease-up. At that point, there is little, if any, additional interest payable to justify the lender’s risk. Lenders can impose prohibitions on selling projects early or prepaying participating loans, but those measures do not protect lenders when there are casualties and takings, or when defaults by borrowers force lenders to commence foreclosure. To address the early repayment problem, lenders can require prepayment premiums based on lenders’ expected investment returns.
In any event, when participating loans are repaid following acceleration or at maturity, lenders need project appraisals to determine the amount of additional interest payable.
A Trio of Legal Considerations
Participating loans raise three legal issues; namely, usury, partnership liability and prohibitions on “clogging the borrower’s equity of redemption.”
Usury laws vary from state to state, so lenders who make participating loans must be mindful of state laws restricting interest rates. Well-drafted loan documents include clauses providing that if additional interest payments are deemed usurious, such payments are recharacterized as principal payments.
Participating lenders should also take care not to be treated as partners or joint venturers with their borrowers. One benefit of being a lender, instead of an equity partner, is that lenders’ risks are presumably limited to their loan amounts. Lenders who are treated as their borrowers’ partners have exposure to additional losses due to premises liability or releases of hazardous materials. Also, if a court rules that a lender is acting as its borrower’s partner or joint venturer, the lender’s right to foreclose can be compromised. Most loan agreements include language explaining the economic reasons for additional interest payments and stipulating that the lender is not the borrower’s partner or joint venturer.
Participating loans raise three legal issues; namely, usury, partnership liability and prohibitions on “clogging the borrower’s equity of redemption.”
The problem of “clogging the borrower’s equity of redemption” arises from the ancient legal doctrine that gives defaulting borrowers the equitable right to stop foreclosure sales by paying off their loans, with interest, before foreclosure. In traditional loan arrangements without additional interest, it is easy to calculate the total amount of principal and interest needed to pay off the loan and prevent foreclosure. In participating loans, however, quantifying additional interest owed to the lender is more difficult. This difficulty impairs borrowers’ right to pay off participating loans upon default, and potentially “clogs” their equity of redemption.
Christopher Vaccaro
To prevent this problem, participating loan arrangements should require project appraisals prior to foreclosure, so the amount of additional interest attributable to appreciation can be quantified. This allows the parties to calculate how much money is needed to pay off the loan with additional interest prior to foreclosure. If the default occurs before the lender realizes its expected return on investment, the loan documents should allow the lender to charge an appropriate prepayment premium.
Proper documentation is essential for participating loans. With the right loan structure and careful documentation, lenders can share in the upside of their borrowers’ projects and reap better rewards for their risks.
Christopher R. Vaccaro, Esq. is a partner at Dalton & Finegold, L.L.P. in Andover. His email address is cvaccaro@dfllp.com.
