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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   February 2014

Due-Diligence Deposits: More Friend Than Foe

Upfront fees may signal serious lender-borrower partnerships

Due-Diligence Deposits: More Friend Than Foe

Commercial real estate financing is regaining popularity, but with many differences compared to how it functioned before the financial meltdown. One significant change that borrowers now face is that many lenders currently require them to cover their own due-diligence fees as part of the transaction.

Gone are the days when popular borrowers could stride into local banks, ask for loans and walk out with the money already transferred into their accounts. Although this remains true of a few banks that still maintain intimate relationships with their largest customers, the vast majority of lenders appear to be putting on grim masks and conducting business in a different manner.

Borrowers who may be alarmed by the change in lenders’ requirements should beneath the appearance for the actual reasons that may be setting the stage for long, mutually beneficial business connections.

A key reason banks used to cover due-diligence fees was that borrowers were required to maintain significant deposit accounts, providing steady banking business from those clients. Today’s funding sources are usually private lenders, private-equity companies, hedge funds, lending consortiums and other financial institutions. They function differently from banks that simply could write off expenses incurred when a project did not close, without negative financial ramifications for initiating and participating in the transaction. In other words, due-diligence expenses are costs that current lenders can’t recover or write off in ways banks once could.

Current fees

To maximize their potential for successful closings and minimize time with borrowers who are not committed, many lenders require an upfront deposit of a specified amount of money for due-diligence activities. In addition, these charges may include legal fees as well as costs of environmental, title, geological, forensic accounting and real estate studies. This also may include other cost areas that must be evaluated before a funding decision can be made. The borrower’s background in similar projects also must be vetted.

The amounts requested for due-diligence deposits vary greatly from lender to lender. Many lenders that provide large-scale funding require a percentage amount of the total funds requested, usually in the 0.5 percent to 1 percent range. For example, a $100 million funding request could cost the borrower from $500,000 to $1 million in upfront fees. The same $100 million request may require only a $50,000 payment from another lender, so the combinations and permutations are endless — going from as low as $2,500 to $10,000 in some cases — depending on the amount of financing being sought. Despite the variance in fees, there often are few differences in the due-diligence activities and determinations made by different lenders; each lender has set criteria that must be met by each property or project it investigates.

The goal of lenders is to establish a partnership with the borrower to accomplish the funding. This is especially true when equity participation is required. The funding source is working to create a presentation for its investors that will be convincing enough to justify its involvement. The lender also may be concerned that if a borrower doesn’t have enough confidence in the project to put up the due-diligence deposit, why should anyone else be willing to put up such a large amount of funding for that person? Considering that a $25,000 due-diligence payment could yield a $10 million funding amount, upfront payment is only one-quarter of 1 percent of the total amount being sought, so it shouldn’t be considered exorbitant or prohibitive by a serious client.

There is currently so much lending business available that funding sources are in a position to pick and choose which projects and individuals to work with. One manner of eliminating prospective borrowers who may not be serious or committed is by making them responsible for the costs of due-diligence activities on their projects. Borrowers who don’t believe that they have viable projects or are not interested in moving forward certainly will not be willing to make the required upfront deposit of funds. This serves to reduce the possible borrowers from the pool of potential clients and helps the funding sources come out of the process with the best selection of borrowers to work with.

Preparing clients

Commercial mortgage brokers understand that funding sources are held accountable to their investors for their decisions and cannot simply write off losses without serious consequences, hence the need for the due-diligence process. Lenders must be in a position to assure their investors that any given loan undertaking was prudent, even if it does not close; for example, if due diligence uncovers an insurmountable obstacle to the completion of the project being funded.

Just as the borrower is seeking a commitment from the funding source, the same is happening in reverse. The funding source is seeking a committed borrower who will see the process through to the end. These sources are not interested in borrowers who may change their minds suddenly and go elsewhere in the middle of the due-diligence process, which may take as long as 60 to 90 days, depending on the complexity of the project. The payment of the due-diligence deposit serves to guarantee the allegiance of the borrower throughout the process. If the borrower walks away, the lender at least has covered the costs of the due-diligence activities and has not wasted time and resources completely.

Mortgage brokers, who understand the reasons for and necessity of upfront due-diligence, should help their clients understand that for these reasons, the funding sources are seeking financial partners, not “tire kickers” or people shopping around looking for the best deal. Additionally, brokers should provide clients all the details about what fees, activities and studies the funding source will be undertaking in the due-diligence process.

Is escrow an option?

Borrowers often request that their due-diligence deposits be held in escrow, which lenders rarely allow. First, many lenders consider such a request an implication that the borrower considers them untrustworthy. Second, the purpose of the due-diligence deposit is to cover costs incurred by the lender plus any third-party fees incurred. Funds in an escrow account cannot be drawn down to make payments as activities are completed and invoiced.

The usual reason for borrowers requesting funds be put in an escrow account is so the money may be recovered if the transaction doesn’t close. But many transactions that fail in due diligence are because of the borrower, such as for failing to disclose material facts, or for reasons that are beyond the control of either of the parties involved, such as environmental contamination. 

Mortgage brokers, however, can assure uneasy clients that escrow isn’t actually necessary. When a due-diligence deposit is paid, the lender typically creates a written document outlining what activities will be performed and in what order. With the contractual commitment of such a document, the borrower can be assured that the due diligence is being pursued. The contract should ease the borrower’s worry that nothing is being done or that the funder eventually could walk away from the transaction, for whatever reason. In cases where a transaction does not close, lenders usually will return any portion of the due-diligence deposit that has not been spent.

Benefits

Another way of looking at required due-diligence fees: As in many things, “you get what you pay for,” and funding sources that require an upfront deposit are likely to provide additional benefits to the borrower as well as the peace of mind of a contractual commitment.

For example, lending consortiums offer many advantages when it comes to due-diligence fees. In some cases, the fee will cover future financing applications by the client, as well as the current one. This means that if borrowers need additional funds in the future — even millions of dollars — they will not be charged another due-diligence fee.

In many cases, the due-diligence deposit also will be credited back to the borrower at closing, which means it would be deducted from any other lender fees that must be paid. In other words, the borrower comes out of the situation with a closed loan that did not cost anything for the due-diligence process. The lender’s fees for the closed loan are reduced by the amount of the due-diligence deposit. Of course, there are as many types of these fees as there are lenders; each funding source is different and applies its rules to due-diligence fees. Many lenders do not deduct these fees from their fees at closing.

• • •

The logic behind due-diligence deposits should make perfect sense to commercial mortgage brokers who can take advantage of this knowledge to educate clients that a due-diligence deposit shouldn’t be viewed as an upfront fee, but rather as an investment in proving a project’s viability and worth of serious consideration by a capable funding source. The key, from the mortgage broker and borrower’s standpoint, is not to try to avoid due-diligence fees, but to find the lending source that will fund the highest dollar amount and do the most thorough due diligence at the lowest cost.

The reality in today’s commercial market is that virtually every major funding source requires some kind of deposit for due-diligence activities. It has become such a norm that serious borrowers should be skeptical of any lenders that don’t require such a deposit.


 


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