By David Kanarfogel, Partner, Kanarfogel & Srolovitz LLP
In anticipation of a potential credit crisis in commercial real estate finance, borrowers are well-counseled to be aware of various measures that lenders are taking to mitigate any surge in defaults, including an increased willingness to create loan workout options and offer complex credit solutions.
In this article, attention will be given to another component of commercial credit that can trigger unexpected problems but that also affords opportunities to borrowers to positively differentiate themselves in a constrained credit environment: loan covenants.
Commercial loan covenants are contractual provisions that borrowers agree to comply with as a condition of obtaining a loan. These covenants aim to protect lenders’ interests and ensure that borrowers maintain certain financial and operational standards throughout the loan term.
Breaching a commercial loan covenant can have serious consequences for borrowers. When a covenant is breached, it typically triggers a default event under the loan agreement. The lender may have the right to accelerate repayment of the loan, demand immediate payment of outstanding principal and interest or take legal action to enforce the terms of the agreement.
Breaching a covenant may also result in a loss of trust and confidence from the lender, making it challenging to secure future financing. Therefore, it is crucial for borrowers to carefully monitor their compliance with loan covenants and take proactive steps to avoid breaching them.
Here are some key and typical provisions that borrowers might find in their loan agreements:
- Debt Service Coverage Ratio (DSCR): The DSCR covenant measures a borrower’s ability to generate sufficient cash flow to cover its debt service obligations. It is calculated by dividing the borrower’s operating income by its debt service payments (principal and interest). This covenant provides lenders with assurance that the borrower has adequate cash flow to meet its loan repayment obligations.
- Minimum Liquidity: A minimum liquidity covenant requires the borrower to maintain a certain level of liquid assets, such as cash or marketable securities. This covenant ensures that the borrower has readily available funds to meet its short-term obligations. For example, a covenant might stipulate that the borrower must maintain a minimum liquidity level equal to three months’ worth of debt service payments. This helps mitigate the risk of default caused by liquidity shortages.
- Maintenance of Occupancy: A maintenance of occupancy covenant is commonly found in loan agreements for multi-tenant commercial properties. It requires the borrower to maintain a minimum level of occupancy throughout the loan term. For example, a covenant might mandate an occupancy level of at least 80 percent at all times. This ensures that the property generates sufficient rental income to support the loan payments and reduces the risk of income disruptions caused by high vacancy rates.
- Restriction on Additional Debt: This covenant limits the borrower’s ability to incur additional debt without the lender’s consent. It prevents the borrower from taking on excessive financial obligations that could impair its ability to service existing debt. The covenant may specify a maximum amount or a debt-to-equity ratio that cannot be exceeded. By restricting additional borrowing, the lender safeguards its position and minimizes the risk of overleveraging by the borrower.
- Capital Expenditure (CapEx): A CapEx covenant sets requirements on the borrower’s capital expenditures. It ensures that the borrower allocates sufficient funds to maintain and enhance the property securing the loan. For instance, the covenant may require the borrower to spend a minimum percentage of the property’s net operating income on capital improvements each year. This covenant helps preserve the value of the collateral and protects the lender’s investment.
- Change of Control: A change of control covenant is triggered when there is a change in ownership or control of the borrowing entity. This covenant requires the borrower to obtain the lender’s consent or take specific actions in such circumstances. It protects the lender’s interests by ensuring that the new owners or controlling parties meet certain qualifications or fulfill obligations outlined in the loan agreement. The covenant helps maintain stability and ensures that the borrower remains creditworthy even after a change in control.
Naturally, the exact terms and conditions of these covenants can vary significantly depending on the specific loan agreement and the parties involved. It goes without saying that it is recommended to consult with legal and financial professionals to ensure a clear understanding of the implications and obligations related to loan covenants. Virtually all of the above covenant examples can be negatively impacted by rising interest rates and inflating operating costs, so a review of outstanding covenants may be in order to prevent an unexpected breach.
However, when faced with a potential breach, it’s not necessarily good practice to avoid sharing information with your lender. Borrowers who diligently maintain their loan covenants and open communication with their lenders throughout the loan term will be in favorable positions when their loans mature, particularly in terms of finding credit partners for future financing needs.
By consistently meeting their obligations, borrowers demonstrate their reliability and commitment to fulfilling their financial responsibilities. This reliability enhances their reputation in the lending market and builds trust with potential credit partners. Additionally, proactive communication with lenders allows borrowers to address any challenges or concerns promptly, seeking assistance or renegotiating terms when necessary.
Some communication may be contractually obligated — many loan agreements have notice requirements that cover anticipated breaches or defaults. But regardless, transparent and collaborative communication with lenders can showcase a borrower’s commitment to financial stability and responsible borrowing. As a result, when their loans mature, these borrowers are more likely to attract credit partners who appreciate their track record of covenant compliance, trustworthiness and effective communication, making it easier for them to secure continued access to credit.
Borrowers who position themselves as favorable are especially advantaged in times of credit contraction, when lenders become more selective. Adhering to loan covenants and maintaining good partner relationships enables borrowers to differentiate themselves and gain a competitive edge in securing the limited available credit.
— Kanarfogel & Srolovitz LLP is a New York-based corporate law firm specializing in real estate, finance and trust cases.