Financing Focus

Why Comply?

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 time.

Ignoring 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 covenants.

Common Covenants

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.

Failure 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 consequences.

For 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.

If a 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.

Commercial 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 statements.

Take Action

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 borrower.

Instead, 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.

Lenders 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.

New 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 default.

To 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.

Property 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


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