Assets America® continues its series on standard CRE terminology with this article about loan proceeds. In this article, we cover:
- What are Loan Proceeds?
- 8 Common Fees and Expenses
- Formulas & How To Calculate
- Helpful Examples
- Uses of Net Loan Proceeds
- Important Legal Considerations
- Frequently Asked Questions
What Are Loan Proceeds?
Loan proceeds are funds distributed from a loan, less closing costs. In this article, we will concentrate on the proceeds from commercial real estate (“CRE”) loans. However, issues surrounding loan proceeds apply to all sorts of loans. Normally, borrowers receive CRE loan proceeds at, or soon after the closing of a loan transaction.
Typically, lenders distribute the proceeds either directly to the borrower or to a third party. Specifically, the third party applies the funds to various expenses. The loan agreement specifies the amount of the loan, it’s interest and payback terms. In some cases, the loan may carry a prepayment penalty that discourages the early payback of a loan.
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Fees and Expenses
The loan agreement lays out all the particulars concerning the loan. These include any fees and expenses that pay for preparing and extending the loan.
1. Origination Fee
This is a fee that lenders charge for originating a loan. Typically, an origination fee can be anywhere from 0.5% to 5.0% of the total loan amount, depending what type of loan it is and which type of lender is funding the loan. For example, consider a $10 million loan with a 1% origination fee.
The lender will subtract $100,000 from the loan proceeds to cover the origination fee. Normally, lenders justify the fee to pay for initial processing and underwriting a loan application. In fact, part of the fee is pure profit for the lender. Sometimes, we call origination fees points or discount fees, especially when the fee is a whole point amount, such a 1% or 2%.
Borrowers can seek to reduce the origination fees they pay in return for their business. Naturally, this is a better tactic if the borrower has multiple offers. But borrowers should be realistic and not expect lenders to work for free. On the other hand, smaller loans may require a larger origination fee to cover the lender’s fixed costs.
Realistically, borrowers shouldn’t expect for lenders to work for free. Generally, borrowers may be better off paying a higher origination fee in exchange for a lower interest rate. Certainly, that’s truer for long-term loans where the interest you save might surpass the origination fee. Under no circumstance should the origination fee amount be a surprise at the closing.
2. Underwriting Fee
This is the fee to cover the lender’s costs for underwriting a loan. Definitively, underwriting is a process in which the lender assesses the creditworthiness of the borrower. Specifically, the underwriters want assurances that the borrower repays the loan in full and on time. The fee amount depends on:
- The borrower’s credit history
- The loan type
- The loan size
- The lender’s loan program
3. Title Insurance
The title agent is responsible for insuring the borrower has clear title to the property. This covers the borrower if a challenge to the rightful title arises. It protects the title insurance holder(s) from liabilities arising from insufficient title or lien searches.
4. Real Estate Taxes
If you are acquiring a property, then you might have to pay prorated property taxes at the closing. Specifically, you must pay your prorated portion of property taxes so that the seller gets credit for its payments. The seller may be due a refund of the real estate taxes it previously paid. Naturally, this occurs when the seller has paid taxes in advance for the full period. The seller pays taxes for the partial period up to closing and receives a refund of the rest.
5. Commercial Property Insurance
This insurance protects both the lender and the borrower against damage to the property. The cost depends on:
- The value of the property
- The loan amount
- The property location
- Any specific risk factors
6. Broker Fees
Naturally, this is the fee to pay for a loan broker’s services. It can be a flat fee (though is extremely rare), a transaction percentage, or some combination of both. However, it is almost always a percentage of the loan amount.
7. Lender’s Legal Fee
Sometimes, the lender has the borrower pay for customary legal costs arising from the funding transaction. Loan size and details of the loan and/or property factor into the legal fee.
8. Other Closing Fees
These would be any other closing fee the lender charges for conducting the closing. Specifically, the lender type and the state in which the closing takes place are factors in these fees.
How to Calculate Loan Proceeds
The formula for calculating net loan proceeds is:
Loan Proceeds = Loan Amount – Closing Costs
Expect closing costs to range from about 3% for simple refinancings to 10% for complex transactions. Typically, a neutral third party, such as an escrow agent, will oversee the closing and direct payments to various parties.
Suppose you purchase an apartment building for $10 million. Furthermore, the total closing costs amount to $460,000. Therefore, the loan proceeds = $10,000,000 — $460,000, or $9,540,000. Accordingly, you receive a cashier’s check for that amount from the lender via the escrow agent conducting the closing.
Alternatively, you can direct that the lender deposits the money directly into your bank account. It might take several days for the lender’s payment to clear the bank.
Use of Loan Proceeds
The loan agreement may limit how the borrower can use the loan proceeds. Indeed, government-backed loans may enforce strict limitations.
On the other hand, sometimes you are free to use the loan proceeds in any way you see fit. For example, you might refinance a building in order to extract equity.
You can spend the cash-out portion freely. For example, you might use the proceeds to finance other deals, consolidate debt or purchase a new yacht.
What is a loan proceeds check?
This is a check for the loan proceeds that the bank or other lender issues to the borrower. Note that under the uniform commercial code (UCC), the check qualifies as a cashier’s check or teller’s check. Therefore, it is subject to all UCC regulations involving these types of checks.
Are loan proceeds taxable for a trust?
Typically, loan proceeds are not income and are not subject to income tax. That would be the case for a trust that receives loan proceeds. However, if the money is really a payment masquerading as a loan, the trust should treat it as income. If the trust was not tax-exempt, then it would have to pay taxes on the fake loan.
How do I book loan proceeds that I haven’t yet received?
Usually, after closing you credit a liability, such as notes payable, and debit an asset. Specifically, the credit is for the full amount borrowed, not just the proceeds. You book the difference between the loan amount and proceeds as one or more expenses. Until you receive the proceeds, carry them on your books as the asset ”loan proceeds receivable.” Finally, once you receive disbursement, credit the receivables account and debit cash.
What is the best use of proceeds from a high-risk loan for the lender to approve?
Typically, the best use of proceeds is to first repay any existing loan. Then, the best use is to apply the funds for a specific use. Of course, that use depends on the nature of the loan. For example, it might be to fund the acquisition or construction of CRE.