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Do borrowers know the true cost of their loans?

The Terrafirma brothers were a confident pair -- or at least as confident as you can be when you're sitting down to sign your way into millions of dollars of debt. After years of buying and renovating small strip malls throughout Chicagoland, they had built an impressive real estate portfolio and were about to make their first really big buy.

The application for a loan on the $5 million community shopping center was a snap -- a quick call to an 800 number. The quote was a nice surprise, about 15 basis points lower than others they'd checked. And their attorney had reviewed the mountains of documents, putting his juris prudent stamp of approval on the deal.

So they took out their pens. And signed themselves into paying around $80,000 more than expected over the life of the 10-year loan.

The Terrafirma brothers don't exist, of course. But their dilemma is all too real. Everyday, experienced borrowers are being deceived about the true cost of their loans.

How does it happen? The answer lies in the way many investment bankers price their loans. They quote a lower interest rate, but use an actual days/360 calculation to figure the payments. Until recently, the equal payment method based on 12, 30-day months had been the standard. It's simple math: 365 vs. 360. More days mean more money.

Lenders don't point out this variation, and frankly there is no obligation to do so. This practice (started by Nomura Securities and now employed by other firms such as Lehman Brothers and First Boston) is all quite legal.

It is also quite misleading, possibly fraudulent. And it's occurring with increasing frequency.

Competition in the CMBS market More and more commercial borrowers today are bypassing banks, S&L's and insurance companies. Instead, they choose lenders who specialize in real estate securitization, that is, turning real estate mortgages into bonds. For residential mortgages, such a market has existed for nearly two decades. The industry known as Commercial Mortgage-Backed Securities (CMBS) has reached critical mass only in the past five years.

The market for securitized loans is hot. Spreads are tightening, and deals are lost over as little as five basis points. So, in an effort at one-upmanship, some lenders -- who are otherwise fine firms -- are playing down and dirty. (What borrower or broker wouldn't be thrilled with a price that looks 15 basis points lower?)

To understand why competition has become so cut-throat, let's review the numbers. We're talking about tenfold growth innew CMBS issues, from $3 billion in 1993 to $30 billion in 1996 -- dramatic evidence of investor interest.

Though CMBS growth has been nothing short of phenomenal, this is a market that's still in its infancy. These securities were originally viewed as a temporary solution to the early-'90s real estate crunch and subsequently used as a vehicle for the Resolution Trust Co. to package and sell loan portfolios.

Even though traditional lenders have returned to real estate, the CMBS market has continued to surge, with some experts predicting volume to double to $60 billion by the year 2000. Spurring the expansion is the addition of property types such as hotels, mobile home parks, nursing homes and storage facilities to the traditional real estate core of apartments, shopping centers, office buildings and industrial complexes.

In other words, properties bought and financed by more and more business people like the Terrafirmas.

Main Street, not Wall Street Actually, these are the people who do the bulk of the borrowing right now -- not the giant companies, not the professionals doing hundreds of deals a year. Customers who borrow only once or twice or three times a year account for nearly 90% of the deals and around 60% of the dollars that make their way into the CMBS market. They are Main Street, not Wall Street.

Deceptive pricing doesn't harm the pros. "Only once has a lender even tried to pull that actual days vs. the traditional 30-day nonsense on us, but we caught it right away and refused to do the deal: 360 or not at all," says one commercial real estate developer. "It just doesn't happen here; it's one of the items on our checklist.

"We're all from commercial banking or S&L backgrounds, so we're familiar with that tactic, but for people who make loans less frequently, it hurts. They don't know that there are different ways to calculate interest. Not even their attorneys spot the problem; it's a hugely overlooked area."

A broker who's been in the business for over 30 years agrees that typical borrowers are "simply unaware that ultimately they're paying a higher rate. The documentation for CMBS loans is so overwhelming. I think they measure them by the pound. This is still a relatively new business, and it's evolving. New players arrive almost daily, so it's become very competitive."

More days, more money for the lender Competition, however, typically benefits customers. Unfair pricing does not. The actual days/360 calculation can put another $6,700 to $8,000 in the lender's coffers, the equivalent of 14-17 basis points more than the stated interest rate. Over the life of a typical 10-year loan, that adds up to serious money.

They payment process for "actual days" varies by servicer and can create problems for the borrowers in other ways. Assuming a 9% interest rate, the principal and interest would vary widely from month to month under one method, from $43,358 in January to $39,162 in February. Unnecessary servicing complexities arise for the loan servicer, bond trust trustee and bondholders.

Those are all important players in the CMBS industry, but none are so crucial as the customer. It's simply unconscionable to allow this practice to continue. Have we forgotten that misleading practices in the residential real estate market forced Congress to regulate the mortgage market and press for clear disclosures? It would be unwise for members of our industry to believe we're immune to similar government scrutiny.

Our customers have their hands full, building their businesses and enjoying the fruit of their considerable labors. They shouldn't have to worry about their lenders' ethics. The time has come for a return to honest quotes, fair prices and integrity. That's what our customers expect and deserve.

Neil D. Freeman is president and secretary at Chicago-based Aries Capital. He specializes in commercial mortgage banking and brokerage.

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