Ignoring loan covenants is a dire mistake in today’s market.
Until the financial crisis in 2007, banks and other lenders seldom
included restrictive financial debt covenants in their commercial real estate
lending agreements. Today, debt covenants are becoming far more commonplace in
commercial mortgages. Many property owners who are refinancing mortgages that
pre-date the financial crisis will be faced with debt covenants for the first
the requirements of financial debt covenants can have dire consequences for all
property owners. Even borrowers who have structured their businesses to protect
their personal assets may be putting them at risk by failing to comply with
financial debt covenants in their lending contracts. In this market, where
properties have lost value and tenant rosters are slim, owners may not be
meeting their loan-to-value requirements. In particular, small-property owners
who have only a few tenants may risk default if they lose just one tenant. For
these reasons and others, property owners need to pay attention to debt
The following are the two
most common types of financial covenants:
• Debt service
coverage covenants require the borrower to generate enough cash flow to cover a
percentage of their debt payments. Banks typically require borrowers to
generate at least 125 percent of their debt payment annually.
• Loan-to-value covenants require the borrower
to have at least a certain percentage of debt covered by the property’s current
fair market value. For example, if a borrower owes $75 million on a mortgage
and the loan includes a 75 percent LTV ratio, the value of the building has to
be at least $100 million to be in compliance.
to be in compliance with financial debt covenants by any amount, no matter how
small, may technically result in a loan default, which can have serious
instance, the above example of a 75 percent LTV requires a market value of $100
million for the loan to be in compliance. If the building’s value falls to $90
million, the covenant may require the borrower to repay enough principal to
bring the loan into compliance. The borrower could be required to return $7.5
million to the bank to avoid defaulting.
borrower lacks the capital to comply, the bank could initiate foreclosure
proceedings or, if a personal guarantee is in place, look to the guarantor to
make good on the debt requirements. There may be no good options for the
borrower, who at a minimum may lose the investment in the property.In
extreme cases, filing for bankruptcy protection is the only option.
property investors should be aware that auditors pay attention to debt
covenants. If an auditor discovers that a company is not in compliance,
accounting standards require that the financial statements disclose the
covenant violation. The only way to avoid disclosure is for the lender to agree
in writing to waive the ability to enforce the loan covenant for one year from
the date of the financial statements. If the lender is unwilling to agree, the
company will have no choice but to disclose noncompliance in its financial
So what should property
owners do if they are out of compliance?Instinctively, some choose the
worst possible approach — hiding noncompliance from their lenders. The “duck
and cover” approach will possibly cause the bank to take action against the
at the first sign of trouble, the owner should give the lender a full account
of what is happening with the property and how the issue will be
addressed. Most lenders will be flexible as they are not anxious to add
to their foreclosed property portfolios.
do make allowances for extenuating circumstances. They may, for example, take
into consideration one-time expenses or potential new tenants who are almost
ready to enter into a lease. If the owner has a realistic plan to come into
compliance with loan covenants, the plan should be shared with the lender. Lenders will generally be more willing to
work with a borrower who has a plan to comply. The plan should follow the
principals of SMART: Specific, Measurable, Attainable, Realistic, and Timely.
The borrower must present a timeline in which the loan will be in compliance to
have any chance of approval.
owners or would-be owners of commercial property are unlikely to talk a lender
out of including financial debt covenants in a lending agreement, but they may
be able to negotiate more favorable terms. In one example, a client’s loan
included a 75 percent LTV ratio, but the bank agreed that, in case of default,
a personal guaranty only had to be in place for a 50 percent LTV ratio. This
type of arrangement is beneficial to owners of properties with a small number
of tenants, as the loss of a single, significant tenant could result in a
avoid noncompliance, borrowers must know the status of their covenants at all
times and keep the lines of communication with the lender open. It’s important
to recognize that restrictive financial covenants are here to stay, but a savvy
borrower can structure the covenants to minimize personal exposure.
owners must also keep their accountants apprised of significant changes
impacting the business and seek advice if their loan covenants are affected. An
accountant can be the borrower’s strongest ally — and advocate — when it comes
to maintaining good banking relationships.
William C. Jenczyk, CPA, is a principal in the Real Estate Group at
DiCicco, Gulman & Co., a CPA and business consulting firm located in
Woburn, Mass. Contact him at email@example.com.