Nearly all commercial real estate (CRE) transactions are financed with some amount of debt. But, a commercial real estate loan is very different from a residential real estate loan. One of the major ways that they are different is that they typically contain some number of “loan covenants.”
What are Loan Covenants?
A loan covenant is a “promise” made by the borrower to the lender. In most cases, the promise is that the borrower will abide by certain terms and conditions of the loan agreement.
Covenants can be “positive,” meaning that the borrower affirmatively agrees to do something. Or, they can be negative, meaning that the borrower agrees not to do something.
Covenants can be financial, meaning that they pertain to some sort of financial requirement. They can also be operational, meaning that they pertain to property operations, or they can be related to the loan’s collateral.
Covenants are typically negotiated during the underwriting phase of the transaction, and the borrower generally has the weaker position. In many cases, the lender conditions approval of a loan upon the borrower agreeing to a certain set of loan covenants, and there is little these borrowers can do to negotiate them away. However, the larger the loan amount and the stronger the financial condition of the borrower, the more negotiating power they tend to have.
Loan Covenant Examples
Loan covenants are unique to each loan transaction, but they all follow a similar pattern. There is a statement of the covenant and then a condition about how often it will be “tested.” Examples for each loan covenant category are described below.
A financial covenant has to do with the money or cash flow component of the transaction. Examples of potential financial covenants include:
- Liquidity Provision: The lender requires the borrower to maintain a certain amount of cash and marketable securities at all times during the loan transaction.
- Debt Service Coverage Ratio (DSCR): The Debt Service Coverage Ratio is the ratio of the property’s Net Operating Income to the loan payments must meet a certain level, often 1.25X or higher.
- Loan to Value Ratio (LTV): The ratio of the loan amount to the property’s value may not exceed a certain level, often 80%.
- Net Worth: The net worth of the guarantor(s) must meet a certain threshold at all times during the loan term.
In addition to the financial covenant language, the loan documents will typically state how often the covenant will be tested. For example, it could be tested quarterly or annually.
An operational covenant is one that is related to the day to day operations of a property. Examples of operational covenants include:
- Reporting: The borrower may have to submit reports or documents like their roll, tax returns, and/or property financial statements on an annual or quarterly basis.
- Material Adverse Change: The borrower has to prove that there has been no material adverse change in the property or its operations in a given time frame.
In general, the purpose of reporting covenants is to give the lender an early warning about any material deterioration in the performance of the property.
Collateral covenants pertain to the collateral securing the loan. Examples of collateral covenants include:
- Debt: The borrower may not take on any additional debt or place any additional liens on the property without the prior consent of the lender.
- Change in Ownership: The property owner may not change ownership interests without the prior consent of the lender.
The purpose of these types of collateral covenants is to ensure the lender will continue to maintain their first position in the repayment priority in the event of default.
Although there are different types, the purpose of nearly all loan covenants is for the lender to minimize the amount of risk associated with the transaction.
What Happens if a Loan Covenant is Broken?
In addition to describing the covenants, loan documents also describe what happens if they are broken. Again, the specifics vary by transaction, but there are three general steps that a lender can take:
1. Declare a Default
The first step is for the lender to inform the borrower that they have violated one of the loan’s covenants. This is called a “technical default” and it is as serious as a financial default (e.g. missed payments).
2. Cure Period
Once a default has been declared, the lender typically allows for a “cure period,” which is an amount of time that the borrower has to fix the issue. The period could be up to 60 or 90 days, and the borrower must take proactive steps to fix whatever the issue is. For example, if the liquidity covenant was broken, they must deposit enough money to get it back above the required threshold.
3. Lender Takes Action
If the default is not cured in the allowable time frame, the lender can take unilateral action to protect their interest in the transaction. The specific action varies by circumstance, but could include any of the following: initiate foreclosure proceedings, execute on a loan guaranty, exercise the right of offset, increase the interest rate, or accelerate loan payments due. These actions are not pleasant for the borrower, nor the lender, and it is in the best interest of all parties not to let the situation deteriorate to this point.
For many borrowers, the key to managing a technical default is to stay in constant communication with their lender(s), and to be honest and forthright about the situation, including how they plan to resolve it. Lenders do not want to go down the path to foreclosure, and they always have a vested interest in making the deal work.
Interested In Learning More?
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