Refocusing on Loan Covenants as the Commercial Real Estate Market Slows
As inflation, rising interest rates, an uncertain economy and troubles in the banking sector weigh on commercial real estate, property owners are faced with multiple challenges.
These challenges include tenants not paying rent, tenants asking for rent deferrals and lenders becoming increasingly reluctant or unable to provide refinancing or extend maturing debt.
As a result, landlords (aka Borrowers) may look to negotiate a loan modification or short-term extension with their existing lender.
Before reaching out to their lender, Borrowers and their guarantors are advised to revisit their existing loan documents to understand their current loan covenants, including the ramifications of failing to meet them.
Common Commercial Real Estate Loan Covenants
Financial loan covenants, which are negotiated during the loan underwriting and documentation process, are designed to mitigate lender risk and to provide an early warning function. Common loan covenants include:
- Debt Yield (“DY”): Net Operating Income (“NOI”) divided by the loan amount (expressed as a percentage).
- Debt Service Coverage Ratio (“DSCR”): NOI divided by total debt service.
- Loan to Value (“LTV”): Loan amount divided by the appraised value of the asset securing the loan.
- Loan to Cost (“LTC”): Loan amount divided by the construction cost of the real estate project (as opposed to LTV, which compares the loan amount to the market value of the completed real estate project).
- Net Worth: Assets minus liabilities, measured at a point in time. Guarantors are often subject to Minimum Net Worth requirements that are measured, say, annually or quarterly.
- Liquidity: Liquid assets such as cash, marketable securities, receivables, and inventory, measured at a point in time. Like Net Worth, guarantors are often subject to minimum liquidity requirements that are measured, say, annually or quarterly.
Debt Yield (“DY”) does not take the interest rate, amortization rate or property value into account. DY focuses solely on the size of the loan relative to the subject property’s NOI.
Another way of looking at this ratio is to back into the maximum loan amount given a lender’s required DY and the subject property’s NOI. For example, if a property’s NOI is $225,000 and the lender requires a DY of 10%, an acceptable loan amount would be $2,250,000.
Commercial loan documents often include a minimum DY figure, say 9%, that is tested on a periodic basis (i.e. annually with the submission of property financial statements). Some loan documents include stepped minimum DY figures to provide time for the property to stabilize and/or increase rents.
In summary, lower DY means higher risk for the lender, while higher DY means lower risk for the lender.
DEBT SERVICE COVERAGE RATIO:
Debt Service Coverage Ratio (“DSCR”) measures a property’s ability to pay current debt obligations based on available cash flow. DSCR of greater than 1.00x means the entity generates sufficient income to pay current debt obligations. Lenders typically require a DSCR of 1.15x – 1.25x.
It should be noted that lenders may calculate DSCR in different ways. It is important to understand your loan documents and how your lender calculates DSCR. For instance, some lenders calculate DSCR based on actual Principal and Interest (“P&I”) payments, while others use DSCR based on an interest rate which is greater of, for example, (a) 7.5%, (b) actual Note Rate, or (c) 10 Year Treasury Bonds plus 3%.
Some loan documents include stepped minimum DSCR figures to provide time for the property to stabilize and/or increase rents. A higher DSCR translates to increased certainty that debt obligations will continue to be paid from property cash flow.
LOAN-TO-VALUE / LOAN-TO-COST:
Loan-to-value (“LTV”) is the ratio of the loan amount to the value of the asset, while loan-to-cost (“LTC”) is the ratio of the loan amount to the cost of constructing the asset. Both LTV and LTC are measured at a specific point in time rather than over a period.
Construction loans, for instance, may use both LTV and LTC ratios. LTC helps measure the risk of providing financing for a construction project, while LTV measures the risk after construction completion.
The higher the LTC or LTV ratio, the higher the risk to the lender for making the loan. Conditions precedent to loan disbursement often include ongoing LTV and/or LTC requirements.
NET WORTH / LIQUIDITY:
Borrower’s minimum Net Worth and Liquidity are both common covenants that are typically measured based on audited financial statements. Net worth typically excludes intangible assets for covenant purposes. Both Net Worth and Liquidity are measured at a specific point in time, say as of 12/31, versus over a period.
Testing typically takes place concurrent with submission of financial reporting due the lender. If there is sufficient liquidity, Borrowers can continue to pay debt service and other obligations despite a decline in property cash flow.
If a financial loan covenant is not met, loan documents may provide lender remedies such as:
- Immediate loan default with no rights to cure or notice.
- Loan default with X days to cure after notice is served.
- Loan default if, within X days after notice is served, loan is not paid down (or additional collateral is not provided) within X days to meet the failed covenant (i.e. DY, DSCR or LTV).
- Immediate springing cash management (i.e. lockbox,) whereby the lender takes control over property cash flow. Some loans provide that springing cash management can be avoided if the loan is sufficiently paid down (or additional collateral is provided) to meet the failed requirement (i.e. DY, DSCR, or LTV) within X days after notice. Loan documents may also provide an end to springing cash management if a hurdle is met (i.e. DSCR >= 1.25 for two consecutive quarters).
CHALLENGES / SOLUTIONS:
Property owners are faced with increasing challenges but keeping on top of and understanding their loan covenants should not be one of them. Realogic provides loan abstraction services that include providing a summary of loan covenants and related Critical Dates using rAbstract TM SaaS-based abstraction and administration software.
Commercial Real Estate Loan Abstracts
The loan abstract provides a drill-down version of, for example, a 250-page loan document in an easy-to-follow format. Additionally, on a weekly basis, rAbstract TM users receive Critical Dates emails reflecting date-driven actionable items on an 8-week rolling basis (i.e. (A) On 12/31, DSCR is tested. DSCR < 1.25 triggers springing cash management – or – (B) On or before 3/31, Property financial reporting is due lender).
Alternatively, a user can generate a Critical Date report reflecting upcoming actionable items. Critical Dates help manage deadlines and minimize the risk of failing to meet a requirement (i.e. loans may provide for default or a penalty if financial reporting requirements are not met on a timely basis).
Customizable Loan Abstraction Services
Loan Abstraction is completely customizable based upon the individual needs of our clients. In addition to capturing loan covenants, we capture a variety of attributes including basic loan terms, guaranty information, financial reporting requirements, lease approval rights, and permitted transfers.
Realogic provides a second set of experienced eyes to navigate your complex loan documents. We can identify conflicting information and potential drafting issues.
Another benefit of rAbstract TM is that the loan documents are uploaded to a SaaS-based system and are accessible from any location. This is especially important with more individuals working offsite.
We recognize that loan abstraction is becoming increasingly important given today’s commercial real estate environment. As owners consider lease modifications and/or rent deferments, it is critical that owners fully understand the requirements of their loan documents. If our loan expertise could be of benefit to your firm, contact us at firstname.lastname@example.org.
By Chris Schmuker, Senior Manager, Loan Abstraction, Realogic