Key Priorities for Borrowers in a Bear Market
Tracking the financial covenants in loan documents is a key priority for borrowers in a bear market.
Breach of a financial covenant ultimately may lead to acceleration of the outstanding loan(s). The more likely scenario, however, at least in the short term, is a cash trap (when rent income, which would otherwise have been available for the borrower’s use, is (temporarily) trapped into a blocked account and under circumstance may even become subject to a mandatory cash sweep) and a waiver process, whereby the latter almost by definition means more restrictions (for example, on distributions) and payment of a waiver fee as a quid pro quo for waiving the default as a result of the breach and, if necessary, either resetting the covenant and/or invoking a covenant holiday.
Two of the most common financial covenants in real estate loan documents are Loan-to-Value (LTV) and Debt Service or Interest Cover Ratio (DSCR or ICR).
LTV: an LTV breach can be projected based on internal desktop valuations, but – in the absence of (possibly) significant prepayments – it is difficult to prevent. The timing of the valuation and, hence, the breach is, within limits, under the borrower’s control. This could provide an opportunity to discuss an anticipated breach without having one’s back against the wall.
DSCR / ICR: benchmark rate increases are unlikely to cause an ICR or DSCR breach as a result of lenders being required to enter into hedging arrangements to fix the floating limb of the applicable interest rate. However, a single tenant or material tenant’s financial difficulties in a multiple-tenant property may cause rent income to decrease significantly. Headroom in the covenant, for example based on a sufficiently high vacancy rate when drafting the budgets and agreeing on the ICR levels, or indexation provisions in lease agreements to offset loss of rental income, may provide a cushion for a decrease in rental income. Reevaluating tenants and/or the sector in which they operate may warrant borrowers initiating a discussion on the correct(ion of the) DSCR or ICR.
When it comes to tracking financial covenants, if you’re on time, you’re late. This saying is (also) true for discussing financial covenants with your lender(s). By the time a breach is imminent, a borrower is no longer in the driver’s seat, and the credit may no longer sit within the relationship team. Being aware of financial covenants so as to address potential breaches and have a commercial discussion with the relationship team will be key in navigating these uncertain times.