Avoiding Costly Loan Document Pitfalls in Commercial Real Estate Financing: Strategic Considerations for Developers in a Constrained Lending Environment

With a significant volume of commercial real estate debt set to mature in 2026 and the first half of 2027, borrowers are entering a refinancing cycle marked by tighter credit conditions and heightened lender scrutiny. Elevated leverage across the financial system continues to constrain access to new debt, placing pressure on developers to secure favorable terms while still properly managing legal and operational risk.

Below are several recurring lender-favorable terms that typically appear in lenders’ standard forms of loan documents and warrant close review.

1. Overly Broad Non-Recourse Carveouts

Non-recourse structures are a defining feature of commercial real estate finance, but their protections can be undermined by overly expansive carveout provisions that expose guarantors to unnecessary and off-market risk. These carveouts fall into two categories: (i) above-the-line carveouts—also referred to as “bad boy” carveouts—which, if triggered, expose the guarantor to liability for any damages incurred by the lender resulting from the relevant bad acts, and (ii) below-the-line carveouts, which trigger full-recourse liability to the guarantor for repayment of the entire indebtedness (including principal, interest, fees, the lender’s enforcement costs, etc.). Each category is discussed in more detail below.

Above-the-line carveouts

Above-the-line carveouts are intended to address losses arising from specific “bad acts,” and expose the guarantor to liability for any damages incurred by the lender resulting from those bad acts. However, imprecise drafting can inappropriately expose a guarantor to  liability for actions beyond intentional misconduct. For example:

• Lenders often draft guaranties to provide that any failure of the borrower to pay property taxes or insurance triggers above-the-line liability. However, that failure is not a bad act by the borrower if the reason was an absence of available cash flow. Operating shortfalls are not bad acts. Similarly, if the lender is holding borrower funds in a tax or insurance reserve account and fails to pay, or make those funds available to the borrower, to pay the relevant taxes or insurance, that is not a bad act on the borrower’s part and should not be an above-the-line carveout.
• Lenders often require borrowers to comply with specified “special-purpose entity (“SPE”) covenants to ensure that the borrower’s assets are not consolidated with assets of an affiliated entity in a bankruptcy proceeding and that the borrower does not become liable—and the lender’s collateral thereby exposed—for the debts or liabilities of another entity. Among those SPE covenants is typically a covenant that the borrower remain solvent and pay its debts generally as they become due. Similar to the previous point, it is important to protect the guarantor by limiting a breach of that SPE covenant to exclude issues arising from merely operating shortfalls.
• An above-the-line carveout for physical damage to the collateral should be limited to damage intentionally caused by the borrower. Physical damage caused by a tenant, for example, should not expose the guarantor to recourse liability to the lender.

Below-the-line carveouts

Below-the-line carveouts impose full recourse liability on the guarantor for the entire amount of the indebtedness, regardless of whether the lender has incurred damages. These carveouts should be reserved for events that fundamentally impair the lender’s collateral position, such as certain bankruptcy-related actions. It is important for this carveout to be limited to voluntary bankruptcy-related events. To include involuntary bankruptcy-related events or a borrower’s general inability to pay its debts as they become due should not be a below-the-line carveout, as that would effectively mean the so-called “non-recourse” loan has become fully recourse to the guarantor. Expanding the below-the-line triggers beyond their intended scope can significantly alter the risk profile of a transaction.

A disciplined approach to defining both above-the-line and below-the-line carveouts is critical to preserving the economic intent of a non-recourse structure and protecting the guarantor for exposure to liability for hidden risks.

2. Post-Casualty Repair Obligations

In the event of significant casualty damage to the property that serves as the lender’s collateral, loan agreements frequently grant lenders the discretion to either apply insurance proceeds to the loan balance or release the proceeds to the borrower to use to restore the property. However, lenders’ form loan documents often require the borrower to restore the property, whether or not the lender makes insurance proceeds available for that purpose.

This creates an inequitable misalignment of risk, because it would mean the lender both gets to apply the insurance to pay down the loan balance, and gets the benefit of having its collateral restored at the borrower’s expense.

The issue is compounded when additional financing is required for the restoration work. If the existing loan requires the Borrower to commence restoration too quickly, that can significantly impair the borrower’s ability to refinance, depending on the mechanics’ lien laws in the state where the property is located.

Clear alignment between the borrower’s access to insurance proceeds and its restoration obligations is important to avoid this inequitable outcome.

3. Restrictions on Indirect Transfers

Transfer restrictions are necessary for purposes of lenders’ regulatory compliance obligations, including the lender’s “know-your-customer” (“KYC”) requirements, which include an obligation that the lender identify and verify the identity of any individual who directly or indirectly owns 25% or more of the borrower and/or directly or indirectly controls the borrower. However, lenders’ form loan documents often impose transfer restrictions that apply well beyond meaningful ownership changes, and without refinement, these overly restrictive provisions are often impractical. Whether the direct and indirect members/partners in a borrower entity are family offices, institutional investors, life companies, or otherwise, there are inevitably going to be indirect transfers relating to estate planning matters, high-level corporate structural changes, or otherwise, that the sponsor member may not even have visibility to, so a requirement to give a lender notice, even if no approval is required, is usually setting a borrower up for an unnecessary foot fault.

Transfer restrictions that focus on material ownership thresholds and actual changes in control tend to better preserve appropriate operational flexibility while still addressing a lender’s underlying risk and compliance concerns.

4. Overly Restrictive Constraints on Unbudgeted Expenses

Lenders’ form loan documents often require lender approval for unbudgeted expenses, even for costs that are not discretionary, such as property taxes, insurance premiums, emergency repairs, and costs of compliance with newly imposed legal requirements. The pitfall here is that the borrower’s payment of these categories of necessary costs is almost always affirmatively required by the loan documents, because they serve to protect the lender’s collateral. To simultaneously restrict a borrower’s ability to pay them without prior lender approval is circular and operationally problematic.

Requiring prior approval for payment of necessary expenses introduces unnecessary friction and can expose borrowers to technical defaults, particularly in time-sensitive situations. Well-structured agreements should distinguish between necessary and unnecessary expenses, allowing for practical day-to-day operations.

A More Deliberate Approach to Negotiating Loan Documents

Loan documents function as a detailed risk allocation framework that can directly influence project performance and long-term value. In an increasingly tight lending market, appropriate scrutiny and refinement of provisions relating to recourse, casualty events, transfer restrictions, and operational controls is important to ensure that financing structures align with both the realities of project execution and the intended allocation of risk consistent with market practices.