One of our blog readers has asked us to discuss letters of credit in commercial real estate lending. A commercial letter of credit is a document in letter form in which the issuing bank, at the request of the applicant, agrees to reimburse a third party (called the beneficiary) upon their compliance with the terms and conditions of the letter.
Letters of credit have been used in international trade for thousands of years. Today they have many other uses which all relate to protecting the beneficiary from certain risks. Examples may be letters of credit to assure that roads will be paved in new developments and assuring that contingencies in sales of businesses will be met, etc. These letter types are referred to as standby letters of credit - if the requester does not meet his obligation, the beneficiary can look to the bank for satisfaction.
Fees for issuance of letters of credit generally run 1% to 2%. The requester is usually required to sign a note which is disbursed when the letter is drawn upon and the issuing bank may require collateral/security for its issuance. An example will help you to get a better feel for letters of credit. Suppose you want to buy a special milling machine from South Korea. The machine is expensive; let's say $150,000. You don't want to pay the manufacturer $150,000 in advance because the machine could be defective, and collecting your $150,000 back from a South Korean company could be a nightmare. On the other hand, the South Korean manufacturer certainly doesn't want to ship the machine to California without some guarantee of payment. The solution is a letter of credit. You go to your bank and request that the bank issue a letter of credit for $150,000 for the benefit of the South Korean company. The bank might charge you $3,000 for the service, and they might require that you leave $150,000 in cash in a blocked account. Your bank would then issue a letter to the South Korean manufacturer that promises to hand over $150,000 in cash when the manufacturer presents a delivery receipt signed by you. The receipt will say that the machine was received in proper working order. Now the South Korean manufacturer will feel comfortable enough to ship the machine. Letters of credit and standby letters of credit (the bank steps up if the requesting party fails to perform) are commonly used in commercial real estate finance in two legitimate situations. The developer of a subdivision may be required to post a letter of credit for the benefit of the county for the cost to pave the roads as a condition of a final map. Another legitimate use of a letter of credit in commercial real estate finance is in bond financing. In bond deals, the bank doesn't actually loan the money to the borrower. Investors loan the money to the borrower. A standby letter of credit from the borrower's bank, however, enhances the loan (reduces the risk to the investors). If the borrower defaults, the bank has to step up and pay the investors. If the issuing bank is a AAA-rated bank or a AA-rated bank, the loan becomes a AAA or AA rated investment. The borrower enjoys a much lower interest rate. It's a pretty good deal for everyone because the investor enjoys the knowledge that his investment is secure, the borrower gets a lower rate, and the bank makes a nice 2 to 3 point fee, and it didn't even have to shell out a penny. DANGER: But there are some slippery con games out there centered around letters of credit. Invariably some poor borrower ends up shelling out some huge advance fee for a letter of credit issued by some no-name offshore bank, and he never ends up getting the actual loan. This author has been in the business of commercial real estate finance for almost 30 years, and I have never known of a letter of credit deal to ever close. If someone out there is trying to convince you to hand over a big stack of dollars for a letter of credit on some large commercial real estate loan ... be very, very careful! You are almost certainly being served up as the main course at some con man's feast. If any of you valued readers have ever closed a letter of credit deal, please email me your experience. I would love to hear about it. You can apply to hundreds of bona fide commercial lenders in just four minutes using C-Loans.com. | 
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