As capital markets have been affected by the COVID-19 outbreak, brokers are returning to a model of brokering loans to private investors and retaining servicing rights to the loan. This provides a recurring source of revenue, separate from the origination fees and other charges collected at loan closing.
Having a strong servicing agreement in place can reduce or eliminate the difficulties encountered when servicing a loan. Below are a few of the terms that should be included in your servicing agreement.
1. Specific Grants of Authority
First and foremost, the servicing agreement should clearly outline the rights, duties, and obligations of the Broker and/or any agent of Broker performing servicing functions on behalf of the Broker. Such functions would include, without limitation, the right to collect scheduled payments, issue payoff statements, accept final payoffs, disburse payments to Lender, and initiate foreclosures.
Many private money brokers outsource the servicing of loans to avoid the harsh penalties of the Department of Real Estate (DRE) in connection with the mishandling of trust accounts. Notwithstanding the burdens of complying with the DRE, the servicing rights to a loan originated by a Broker is an asset warranting compensation. Some Brokers will leave all servicing rights to a third-party servicer, effectively giving up their right to compensation. Savvy Brokers will instead retain servicing rights to a loan and then hire a sub-servicer at a rate far lower than the Broker’s servicing fee.
To illustrate this point, let’s say the Broker retains servicing rights to a $1 million loan for which the Broker charges a servicing rate of 1%. If the Broker subsequently hires a sub-servicer at a servicing rate of 0.5%, the Broker will have made $5,000 in income from the loan for the year. In many cases, the fee Brokers can charge is higher than 1% and the fee sub-servicers collect is lower than 0.5%. This also does not take into account any rights to default interest, late charges, prepayment penalties, etc. that may be negotiated as part of the servicing agreement between the Broker and Lender.
Accordingly, the specific grant of authority should also permit the Broker to hire a third party servicer (or sub-servicer).
2. Fees, Advances, and Reimbursement
There are many ways to profit from a servicing retained loan. Brokers are primarily compensated for servicing a loan by retaining a monthly interest rate spread for the loan, which is effectively the difference between the note interest rate and the interest rate the lender earns on the loan. For example, if the note rate of a loan is 10% and the lender receives 8% interest on the loan it made to the borrower, then the Broker is retaining a monthly interest rate spread of 2%. In addition to monthly interest rate spread payments, Brokers may also seek to retain all or some portion of prepayment penalties, late charges, default interest, and other non-standard fees incurred by the Borrower and payable to the Lender on a Loan.
The servicing agreement should also delineate whether the Broker will have the option to advance funds on behalf of the Lender in connection with the Loan. If funds may be advanced by the Broker on behalf of the Lender, the servicing agreement should outline the way the Lender must reimburse the Broker. More specifically, the servicing agreement should provide the grace period in which the Lender must repay the loan, and the interest rate that will accrue on the amounts advanced by the Broker in the event the advances are not reimbursed by the Lender within the specified grace periods.
3. Waterfall Following Loan Payments from Borrower
To reduce or eliminate the likelihood of not being paid by the Lender for the Broker’s services, Brokers should delineate the manner in which parties will be paid from the proceeds of the Borrower’s loan payment. Specifically, the servicing agreement between the Broker and Lender should note that the Broker shall receive any amounts due to it (including, without limitation, any monthly interest rate spread retained on the loan, servicing fees, unreimbursed advances made on behalf of the Lender, and any other fees or charges reasonably incurred by Broker in connection with the loan) prior to any remaining amount from Borrower’s loan payment being disbursed to the Lender.
4. Foreclosure Transfer
Language should be included in the servicing agreement to allow the Broker to participate in the profits of a sale of the property securing a loan in the event said property is transferred from the loan borrower pursuant to foreclosure or otherwise. In many instances, the Lender will not want to be involved with the post-foreclosure remedies with respect to the property securing a loan. This leaves Brokers with the ability to collect a reasonable sales commission for the post-foreclosure sale of the property on top of any success fee negotiated by the Broker, for the sale price received in connection with the sale property that is in excess of the outstanding loan balance.
When the relationship between the Broker and Lender sours, it’s important to have the ability to walk away from the loan. However, the termination option, if exercised by the Lender, should not preclude the Broker’s retained monthly interest rate spread on the loan. In addition, the servicing agreement should specify that any termination exercised by the Lender shall be accompanied by the monthly interest rate spread which would have been earned by the Broker but for the termination by Lender, or if the property is in foreclosure or post-foreclosure. Another option is to offer some other percentage or fee negotiated by the parties to compensate the Broker for the income he would have earned for the marketing and sale of the property.