A covenant is an agreement or promise between two parties to either engage in or refrain from a specified action. In real estate investments, loan agreements frequently employ financial covenants to provide clarity to the borrower in respect of their responsibilities during the loan term, while also giving vital protection to the lender.
Our guide explains the types of financial covenants frequently used along with the criteria for testing and compliance.
What are financial covenants?
Financial covenants set out the parameters within which a borrower has to operate during the term of a loan.
The financial covenants, which a lender requires in respect of any proposed transaction, will typically be specified in the term sheet which sets out the main commercial terms of the loan.
Although a term sheet is non-legally binding (save for some clauses, e.g. costs), it is important the borrower is confident the financial covenants it is agreeing to are viable. Once the term sheet is signed, its terms will be incorporated in the loan agreement and there is usually no scope for changing the type of financial covenants and their parameters.
Why are financial covenants used?
Prior to agreeing to make a loan, lenders will want to see financial projections showing how the borrower will finance repayment of the debt and payment of the interest. Financial covenants are included in the loan agreement so the lender can check whether or not the borrower is meeting those projections.
It is worth noting that a breach of a financial covenant does not necessarily indicate the borrower is insolvent. Usually, covenant levels will be set so that a breach acts as a warning signal, to enable the lender to proactively prevent a shortfall in recovering its loan.
Common types of financial covenants
Financial covenants in any transaction will vary depending on:
- The purpose of the loan;
- The nature of the borrower’s business; and
- The financial strength of the borrower.
However, the financial covenants frequently found in property investment loan agreements are:
- Loan to value ratio
This covenant translates to how much a borrower is lent, in relation to how much the property is worth. The obligation on the borrower is to ensure the loan amount will not exceed a certain percentage of the market value of the property against which the loan is secured.
- Interest Cover Ratio
This covenant checks whether there will be sufficient profit to cover the loan interest payments.
Interest cover is calculated by measuring:
- The amount of the net rental income (i.e., rental income after deductions of any ground rent under the headlease, property maintenance costs and taxes)
- The amount of interest and fees payable for the same period (usually, a quarter or a twelve-month rolling period).
Interest cover test works on either a “historic” (look-back) or a “projected” (look-forward) basis (or both):
- Historic basis: the calculation is made using the actual net rental income received, in respect of a particular period, in relation to the actual interest and the lender’s fees for that same period.
- Projected basis: the calculation is made using estimated future net rental income receivable in respect of a particular period (on the basis of certain assumptions) in relation to the estimated interest and the lender’s fees for that same period. The assumptions usually provide for the worst-case scenario (including, for example, that a tenant will exercise any available break clause in its lease at the earliest opportunity or will not pay future rent if, at the time the calculation is made, it has been in arrears for a certain period or vacant parts of the property will not be immediately re-let).
- Debt Cover Ratio
If the loan is amortising, the lender may require a debt service cover test which is calculated by measuring net rental income received (or to be received) against the borrower’s actual (or projected) obligations to pay interest, fees and principal under the loan agreement.
How are financial covenants tested?
The loan to value covenant is measured on the basis of the latest valuation of the property carried out by an independent valuer who is acceptable to the lender. The loan agreement will contain a provision specifying how often the lender is entitled to request a new valuation report at the borrower’s costs.
The interest cover and the debt cover covenants are measured on the basis of the financial information and property monitoring reports, which the borrower is usually obliged to provide to the lender. Lenders often have specific preferences about what information they wish to see and in what format. Borrowers will typically want to ensure the information requirements are (where possible) compatible with financial information they are already producing to minimise costs.
Compliance with financial covenants is normally confirmed by the borrower via the compliance certificate, delivered to the lender along with the relevant financial statements and property reports.
What are the consequences of a breach of financial covenants?
Should the borrower breach a financial covenant, which will typically be an event of default, this will usually permit the lender to:
- Request immediate repayment of the loan; and
- Enforce any security it holds.
This is subject to a cure rights clause.
A well negotiated loan agreement should contain a “Cure Rights” clause allowing the borrower to, within a specified period after identifying a breach, provide additional security (such as property or a cash deposit) or prepay a proportion of the loan to remedy the breach.
Any limitations on exercising cure rights are negotiated between the parties at the outset of the agreement.
Borrowers be clear before signing
During the negotiations of any financial covenants, the borrower should maintain ongoing pro forma calculations of all the covenants employed and be confident all will work for the borrower for the duration of the loan term. Sufficient due diligence employed at the outset can significantly minimise the risk of a future breach occurring once the loan agreement is signed.
Hamlins Real Estate Finance team has the skills to ensure our clients are properly advised on the terms of finance documents, including the term sheet and any specified financial covenants. If you have any questions in connection with the above, please get in touch.