Many borrowers are or may be finding themselves in dire straits because of downward pressure on operating profit, reduced rental income streams and/or declining asset values. This may be particularly acute for borrowers who have financed real estate assets, especially shopping centres or retail properties where values have been falling and rental income may fall as a result of voids and tenant insolvency.
In this note, we explain at a high level the financial covenants one customarily finds in real estate finance transactions (albeit we are focusing mainly on the loan to value financial covenant or LTV covenant in this note), how the LTV covenant is breached and the implications of such a breach. We also examine how borrowers and funders can structure their deals to mitigate the effect of a LTV breach or protect against one happening in the first place.
What are financial covenants?
In the UK and continental Europe, financial covenants are largely a promise by a borrower to maintain an agreed financial position and/or asset value during the life of a loan, with testing typically on a quarterly basis. In the US, by contrast, financial covenants tend to be incurrence based, meaning that they are tested only when a borrower is about to carry out a particular transaction (e.g. acquiring a new property into its existing financed portfolio).
Returning to this side of the pond, lenders view maintenance financial covenants as one of the key ways to protect their loan investment by monitoring the value of a borrower’s assets and its ability to service its debt. In times of economic stress a financial covenant breach is often the first event of default to be triggered and a forerunner to a possible payment default. Subject to any cure right (see below), this kind of breach will almost certainly entitle a lender to exercise its rights to accelerate the loan, seek repayment and/or enforce its security.
In real estate finance transactions, financial covenants usually measure two things:
- the rental income stream generated by the borrower’s property/ies against its finance costs (e.g. interest payments). This covenant is usually measured quarterly on a historic basis (i.e. what was actually received less certain deductions or deemed deductions) and a projected basis (i.e. what the borrower expects to receive less certain deductions or deemed deductions). So, historical interest cover and projected interest cover. If principal repayments are included too, then the covenants are called historical debt service cover and projected debt service cover
- the principal amount of the loan against the market value of the property/ies (as determined by the lender’s most recent valuation). So, loan to value or LTV (e.g. if the loan is £1,000,000 and the property value is £1,250,000, LTV is 80% (£1,000,000 divided by £1,250,000 x 100). Just like with home mortgage loans, a high LTV ratio is considered riskier than a lower one. A LTV covenant is often stated as being an all times test (i.e. LTV cannot at any time exceed x%) but in reality it is likely to be tested quarterly with the interest cover financial covenants
But as noted above, we are focusing on the loan to value covenant in this article.
Structuring the deal/setting covenant levels to help avoid LTV breaches
- Headroom: the most obvious way that a borrower can guard against a LTV breach is by building headroom into the LTV percentage, so that some reduction in asset value will not result in the loan immediately exceeding the value of the property.
- Equity cure rights: these should be negotiated at term sheet stage and allow a borrower to cure a covenant breach to avoid triggering an event of default. A borrower with a LTV cure right can usually either:
- deposit into a cure account an amount which if applied in prepayment of the loan on the relevant test date would ensure compliance with LTV
- actually prepay the loan in such amount as would ensure LTV covenant compliance had such proceeds been applied in prepayment on the relevant test date
These cure rights are subject to a time limit for injecting the new funds and limits on how many cures a borrower can have over the life of a deal and when it can exercise them.
Most equity cures in real estate finance deals allow funds credited to a cure account to be returned to the borrower if it is compliant with the LTV covenant on the next two test dates (obviously not counting the funds credited to the deposit account as that would be double or triple counting!). Therefore, if the borrower is confident that the breach was a temporary one, it will select the deposit option because it will get its new funds back 6 months later. By contrast, the new funds are gone forever if it actually prepays the loan.
A borrower will also want LTV to be calculated net of any amount standing to the credit of its disposal account. This is because property sale proceeds are credited to the disposals account and all (or a large proportion) of those proceeds will have to be applied in prepayment of the loan. Therefore, not taking them into account in reducing the principal amount of the loan would result in the loan being artificially greater and the LTV test easier to breach.
- Cash trapping: a borrower may ask for this in conjunction with an equity cure right. A cash trap percentage is set at a lower percentage than the LTV default threshold and provides that when LTV exceeds the cash trap percentage but is less than the LTV default percentage, all surplus cash after debt service that would otherwise go to the borrower is swept into a blocked account instead. This is of course advantageous to the lender as it holds back cash. But it could also be seen as good for the borrower because
- the cash trap mechanism might enable the lender to agree to a higher LTV default percentage threshold
- the borrower will probably have a right to have that blocked cash transferred to it if the cash trap LTV percentage drops below the trigger level on the next two test dates
What happens if a borrower breaches the LTV covenant?
This is something that has recently happened to Oaktree Capital, as reported by Property Week. A trio of its retail assets – The Kingsgate Shopping Centre in Dunfermline, The Rushes in Loughborough and The Vancouver Centre in King's Lynn – have breached their LTV covenants as a result of the value of the centres falling by 18% from £105,000,000 to £86,000,000, resulting in the LTV ratio on Oaktree’s senior debt rising to 78% against a covenant of 75%. Property Week has also reported that other real estate portfolio owners (e.g. Lone Star, New Frontier Properties, and RDI REIT) have all breached LTV covenants on portfolios of regional shopping centres in recent months.
With wider market conditions as they are, we should expect to see more stress placed on the value of retail and shopping centre real estate assets and possibly other real estate asset classes too, together with their related financings. What can a borrower do if it is or expects to be close to breaching (or has breached) its LTV covenant?
Firstly, it is important not to bury one’s head in the sand. The borrower and its shareholders should face up to the issues and problems and start to develop a strategy for dealing with them.
Second, engage with your lender, as many lenders will want to work with a borrower to resolve the problem. Indeed, lenders may offer up some of the following options:
- Forbearance agreement: a lender may agree not to declare an event of default with respect to the LTV breach or exercise any remedies that they may have under the facility agreement for a certain period of time subject to certain conditions (i.e. no further default)
- Covenant reset: ask for a covenant reset. This may avoid an imminent financial covenant breach by re-setting the LTV at a higher percentage. A covenant reset may also be coupled with a revised debt repayment profile and/or an interest payment and/or principal repayment holiday. A lender would typically require one or more of the following as part of agreeing a covenant reset:
- an amendment fee
- an increase in the margin
- an injection of new equity from the borrower’s shareholders
- a lower cash trap percentage trigger
- additional security
- sight of revised financial projections and property valuations
- Full blown debt restructuring: this may be viewed a borrower as a last resort but a borrower and a lender could re-negotiate the facility agreement in much more material fashion to amend and, among other things, extend the debt.
- Refinancing: a borrower may consider refinancing its indebtedness with another lender although this may be more expensive for that borrower if its secured assets have fallen in value.
What we can do to help
Please do get in touch with one of our finance, restructuring and insolvency team if you are a borrower or a lender and would like to discuss any of the issues described in this note.
Andrew Dodds