In a commercial real estate transaction, sellers rely on a buyer’s ability to arrange the financing needed to close the deal. One of the ways that a buyer is able to prove this is to provide the seller with a term sheet and/or commitment letter. While these documents serve a similar purpose, there are material differences that can have an impact on the transaction.
In this article, we’ll define what are a term sheet and a commitment letter in commercial real estate and outline the differences between them.
What is a Term Sheet?
A term sheet is a formal expression of a lender’s interest in providing financing for a transaction. It is not a commitment to lend. The term sheet is a good faith summary of the main points and potential terms under which a loan could be considered. The terms outlined in a term sheet are not final; rather, the terms are intended to be a starting point for negotiations and further due diligence. The content and format of a term sheet vary by lender, but a term sheet generally contains the following information:
- Borrower Name: It may seem obvious, but the borrower in a commercial real estate loan transaction is typically a single-purpose entity formed specifically for the deal. As such, it is necessary to identify the legal name of the potential borrower.
- Loan Amount: The term sheet will outline the loan amount that the borrower will consider lending, but it is usually subject to the receipt of an appraisal and/or other third-party valuation. And it is subject to change.
- Loan Purpose: A description of the purpose for which the loan funds will be used. For example, the term sheet could state “for the acquisition of a 100-unit multifamily apartment building.”
- Interest Rate: An expression of the rate at which the lender would consider extending credit.
- Term / Loan Maturity: An indication of the potential term that the lender would consider. For example, the Term Sheet could state that the loan will have a term of 60 months.
- Monthly Payment: A calculation of the potential monthly payment under the proposed terms.
- Collateral: A description of the collateral that the financial institution will accept as security for the potential loan.
- Guarantor(s): Identification of whether the lender will require the personal guarantee of one or more transaction sponsors as potential security for the loan.
- Performance Covenants: A covenant is a promise made by the borrower to the lender, and the potential financial covenants required are outlined in the Term Sheet. For example, the Term Sheet could state that the borrower(s) are required to maintain minimum liquidity of $100,000 at all times during the loan term, to be tested annually.
- Items Needed for Closing: Loan closing is often contingent upon the receipt and review of additional financial information and financial statements; the Term Sheet will outline the additional items needed. Typically these include things like: tax returns, appraisals, environmental review, financial statements, project plans, and draw schedules. In most cases, this is confidential information and the lender must treat it as such.
- Closing Date: If all terms and conditions are met, the Term Sheet will target a potential closing date for the transaction.
From a timing standpoint, a term sheet is issued early in the life of the loan transaction and it is used by the borrower to show sellers and investors that they are working with a lender for financing.
What is a Commitment Letter?
A commitment letter is a legally binding agreement for the issuance of a term loan or credit facility. The key difference between a term sheet and a commitment letter is that a commitment letter is a commitment to lend. Commitment letters are issued towards the end of a loan’s lifecycle, and only after the transaction has been through a full underwriting and approval cycle. Often, the final loan terms are close or identical to those described in the term sheet.
To be counted as a commitment letter, the document must:
- Be in writing: While oral agreements are known to hold up under legal challenges, commitment letters should be in writing so there is no question about the terms of the loan agreement.
- Include the basic terms: Like the term sheet, the commitment letter should include the basic terms of the loan, such as the amount, rate, pricing, repayment structure, prepayment penalties, voting rights, warranties, and term. Ultimately, these terms make their way into the final loan documents and credit agreement that are executed at closing.
- Provide all of the appropriate legal language and disclaimers to protect both the borrower and lender from any potential disagreements.
The commitment letter is signed by both the lender and the borrower, which typically indicates legal enforceability should any legal challenges arise. The commitment letter is also provided by the borrower to investors and sellers as proof of funding to give these parties confidence that they can close.
Term Sheet vs. Commitment Letter Summary
The key difference between a term sheet and a commitment letter is that a term sheet is provided near the beginning of the transaction and is not a legally binding commitment to lend; it is subject to terms and conditions. A commitment letter is a legally binding commitment to lend, and both parties must follow through or they may face legal consequences.
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