Letters of Credit. A Tool for both Lenders and Borrowers?
Lines of Credit
Most of us are familiar with Line’s of Credit (“LOC’s”). Often secured against personal assets, your home (hence the term Home Equity Line of Credit, or HELOC), or eligible investments LOC’s are a popular form of credit. They are often granted to supplement a mortgage.
Letters of Credit
A Letter of Credit (“LC”) is an all together different credit product, or tool. It is more prevalent in trade and commercial transactions. They have their place as a tool in commercial mortgage lending as well.
What is it? It’s an issuer’s (often a Bank’s) promise to pay, triggered by the performance (or non-performance) of an obligation. In the commercial real estate realm, LC’s are used between Mortgage Lender and Borrower, and between Landlord and Tenant. As such, they are typically referred to as “Standby” Letters of Credit. The benefit of an LC, to either yourself or your Lender, is that it cannot be revoked by the applicant (the party providing the LC to the beneficiary). The issuing Bank is obligated to honour the Letter of Credit according to its terms, whether or not the applicant is aware or agrees to its presentation to the issuing Bank.
How are they used?
LC’s are used extensively in new real estate development. Often for the purpose of “backstopping” borrower/developer performance. An example would be the requirement that a builder post an LC when developing a subdivision. The City may require the additional provision of certain roadworks, or public amenities, often at the final stages of development. Failure to complete this work by the time stipulated, would allow the Municipality to “cash” the LC, and provide compensation for undertaking this work themselves. Here in Canada, municipalities will often require LC’s to secure the performance of site works which may, due to our climate, be necessary to delay for several months.
As a landlord and prospective mortgage Borrower, you may undertake certain costly improvement works for a start-up tenancy where there is added income risk, say a Restaurant. A tenant’s financial strength is the most critical consideration, when entering into a commercial lease. In such a circumstance an LC is often viewed as better security than cash. This is particularly true where a tenant is at risk of declaring bankruptcy in a possible subsequent business failure. Obtaining a cash settlement in such a situation is inevitably a time consuming and often fruitless exercise. Provide yourself, and your lender, the added comfort that an LC contributes.
Lender’s may require an LC from you to qualify for a particular loan amount. The Commitment may stipulate that you lease your building to a certain occupancy level and income, by a particular date. Your inability to do so may permit the Lender to cash the LC . The Lender could use the proceeds to either reduce the principal balance of your loan, or perhaps to create an interest payment reserve.
What you Need to Know
Whether you are applicant or the beneficiary of an LC, understand that an LC is irrevocable. It is a separate instrument from the underlying contract (e.g. a Lease). If properly drafted, (and there are conventions around this), the Bank must honor the document subject to it being presented properly.
If cashed, the beneficiary can typically do what they wish with the proceeds. The amount of the LC then becomes a credit obligation of the applicant. In other words, if you are the applicant, and the beneficiary draws on the LC, you are now indebted to the Bank that granted the LC.
Seek Legal Advice
Perhaps you are obtaining an LC from a tenant, to backstop their rental performance and provide comfort to your Lender. Do ensure the document is drafted properly. Seek legal advice on the proper format and documentation required. You don’t need to be wondering about your ability to realize on this security, when you need it most!
Understand how an LC works, and whether it may be a useful tool for you.