Connections for Success

 

09.30.13

Managing Your Debt-Related Loan Covenants

Since the real estate market crash, commercial mortgages have been more difficult to obtain.  Lenders do not want to expose themselves to the types of losses they have sustained over the last several years and therefore, have become even more critical in evaluating the credibility of potential borrowers and the types of projects they will be financing. To protect their interests, many lenders are requesting more financial information (business and personal), as well as requiring more conditions or restrictions on borrowing including guarantees and debt-related loan covenants.  Loan covenants may require the borrower to fulfill certain conditions or restrict the borrower from undertaking certain actions.  They can be financial, informational, affirmative or negative.  Borrowers that violate any of these conditions risk costly consequences.

Common Debt Covenants

Borrowers should expect debt service coverage covenants and loan-to-value (LTV) covenants in their mortgage agreements, particularly with traditional bank loans.

Debt service coverage requires a borrower to generate sufficient net operating income to service its interest and principal obligations. Lenders often require a debt service ratio of 1.20 or greater, meaning that, for every $1 of debt a borrower must cover in a given period, it has $1.20 in net operating income (NOI) available to service it. If you own a building that goes through a high-vacancy period or incurs a temporary increase in operating expenses, your NOI could plummet, causing you to violate the debt service coverage covenant.

The LTV covenant requires a borrower to maintain a specific ratio of the amount of the loan compared to the value of the financed property. The lower this ratio, the more upfront down payment is required to obtain the loan.  So, if you owe $750,000 on your mortgage and you have a 75% LTV ratio, you’ll violate the covenant if the property’s value slips below $1 million.

Consequences of Noncompliance

Any degree of noncompliance could lead to default or foreclosure. If the property’s value causes a violation of the LTV covenant, you could be on the hook for payments that would bring the loan into compliance.

In the above scenario, if the property’s value falls to $900,000, you could pay $75,000, reducing the amount you owe to $675,000 ($750,000 less $75,000) to satisfy the ratio ($675,000 ÷ $900,000 = 75%). If you cannot pay that amount, the lender can foreclose or seek payment from any guarantor.

Alternatively, you could refinance or renegotiate the loan, and give the lender more in-depth, frequent access to your books and records.

When Expecting Noncompliance

Review the Acceleration Clause of your loan agreement carefully if you suspect you may not be in or will not be able to maintain compliance with your loan covenants.  Violations may result in default or the loan, which can trigger increased interest rates or penalties or the loan being called which may ultimately result in foreclosure if you are unable to secure other financing to repay the loan.

A good working relationship with your banker is especially important if you are experiencing financial difficulties.  The lender at their sole discretion may waive the covenants either temporarily or permanently, but this will depend on your circumstances, history with the lender and your projected plan for remedy of the situation.

If you are nearing noncompliance with a loan covenant of any kind, inform your lender as soon as possible and explain how you hope to remedy the situation. If you have a solid plan, the lender may be willing to modify your terms or extend a grace period. Your financial advisor can assist you in evaluating the circumstances and devising a realistic plan that will appeal to your lender.

If you would like additional information, please contact Christie Gricius at 312.670.7444.

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