Getting charged extra for a late payment is standard protocol in lending practices. Judges, lawmakers and regulators have long agreed there’s an administrative hassle lenders should be compensated for when having to recover money past its due date. But in the commercial real estate industry, there’s a new question related to maturing loans originated before the financial crisis: Can a lender charge a late fee on the full amount of a balloon payment due at maturity?

In the world of commercial real estate finance, the answer to that question can mean a six or seven figure swing in your loan payoff depending on how the loan documents are interpreted. But so far, courts in New York, Michigan, Arizona and elsewhere have split on what the answer is. 

Background

Commercial mortgage-backed securities (CMBS) are essentially the commercial version of the loans made famous in The Big Short, called residential mortgage-backed securities. While those are basically a giant bundle of people’s home mortgages, the commercial version is a bundle of commercial real estate mortgages, such as shopping centers, hotels, apartments, and office complexes. CMBS loans were popular leading up to the financial crisis for both borrowers and lenders because they enabled broader access to capital and enhanced portfolio diversification.

Many CMBS loans were set up with a 10-year term, meaning borrowers had 10 years to repay the loan with monthly payments amortized over a longer period (typically 30 years). At the end of that period, the final payment “balloons” to include the entire unpaid principal balance. Now that we’re approaching the 10-year anniversary of the crash, and we find ourselves in a rising interest rate environment, a growing number of borrowers are having trouble selling the property or refinancing the loan to cover the balloon payment.

Let’s say it’s a $10 million loan amortized over 30 years with an interest rate of 6 percent and a 10-year term. If you’re even one day late on the balloon payment, a 5 percent late charge would cost approximately $422,000. But if you were one day late on the normal payment the month before (disregarding any applicable grace period for illustrative purposes), the late charge would only have been approximately $3,000.

Courts Take Up the Question

Some borrowers have sued, arguing that the late charge should only apply to their regular monthly installments – not the entire balance of the loan due at maturity. Courts in California, Arizona and New Mexico have agreed with the borrowers, while courts in Michigan, New York and New Jersey have sided with the lenders.

Those cases have come down to two key questions. First, how clear are the loan documents about this charge? As the various conclusions the courts have reached indicate, the documents are all over the map on this point. Some contracts are extremely clear that the late charge will apply to the balloon payment. But if the documents can plausibly be read to limit late charges to the recurring monthly installments, that’s what judges have tended to do.

A lot of cases stop there. But if the documents indicate that the charge is allowed, courts move on to a second question: Would allowing the lender to assess a late charge on the balloon payment constitute a “penalty” under applicable state law concerning liquidated damages, and thus be contrary to public policy? The Arizona Supreme Court recently ruled that the answer is yes, reversing a trial court ruling which had allowed a $1.4 million late charge in favor of the lender.

Takeaways and Next Steps

Whether lenders can assess late charges on the entire balance due at maturity is an issue that will continue be resolved on a state-by-state basis, with a likely proliferation of decisions going both ways on that question. It will continue to be an important issue in commercial real estate finance, especially as a large wave of those loans originated before the crisis come due this year.

If you are a lender with a loan that is getting close to maturity, you should review the documents carefully to see how clear they are on this point. Please don’t hesitate to contact me for help with that analysis.