Loan Covenant

How loan covenants work

When you sign a commercial loan, you do more than promise to repay it. The loan agreement, mortgage or deed of trust, and any guaranty contain a list of continuing promises. Those promises are the loan covenants. They exist because a lender is exposed to the property and the borrower for years after funding, and it wants contractual early-warning signals and control points during that time instead of discovering a problem at maturity.

Covenants differ from the other things you meet at closing:

• Conditions must be met before the lender funds (appraisal, title, insurance certificates). The commitment letter lists them. Once the loan closes, they are done.
• Representations are statements of fact on the closing date (the entity is in good standing, the rent roll is accurate). A false one is a breach, but it is a statement about the past.
• Covenants look forward. They apply every day until the loan is paid off.

Covenants fall into three groups, and most commercial loans contain all three.

The three types of covenants

Affirmative covenants: things you must do

These require action on a schedule. Typical items include:

• Delivering annual financial statements for the borrower and operating statements and a rent roll for the property, and often tax returns for the guarantor
• Paying real estate taxes and insurance premiums on time, often through escrows and impounds
• Keeping the required insurance coverage in force and naming the lender
• Maintaining the property in good repair and complying with laws
• Keeping the borrower entity in good standing and preserving its separate existence

Negative covenants: things you must not do without consent

These restrict what you can do with the property, the entity and the debt:

• No sale or transfer of the property, or of a controlling interest in the borrower, without the lender's consent (see loan assumption)
• No additional borrowing secured by the property, and no unauthorized second lien or other subordinate financing
• No major alterations, demolition or change of use
• No lease of a significant amount of space on non-market terms, or termination of a major lease, without approval
• No merger or dissolution of the borrower

Many of these are the same acts that appear in bad boy carve-outs. The difference is the consequence: an ordinary negative covenant breach is a default under the loan, while a carve-out breach can also make someone personally liable.

Financial covenants: numbers you must keep

Financial covenants set a measurable threshold that the borrower, property or guarantor must meet on a test date. In commercial real estate the common ones are:

• Minimum DSCR: net operating income divided by annual debt service must stay at or above a stated multiple.
• Maximum LTV: the loan divided by a re-appraised value must stay at or below a stated percentage. This one is harder for the borrower to control, because it can move with the market.
• Minimum debt yield: NOI divided by the outstanding loan balance.
• Guarantor tests: minimum net worth and minimum liquidity, tested on a schedule. See guarantor / key principal.
• Occupancy or leasing tests: a minimum occupancy percentage, or minimum leasing progress on a transitional property.

A tested covenant can be a pass/fail default trigger, or it can trigger a softer consequence first, such as a cash sweep or reserve that traps excess cash flow until the ratio recovers.

Worked example: a DSCR covenant

Assume a $1,400,000 loan at an illustrative 6.5% on a 25-year amortization. The monthly payment is $9,453 and annual debt service is $113,435 (calculated with our DSCR calculator). The loan agreement has a minimum DSCR covenant of 1.25x, tested annually.

Property NOI	DSCR	Result on the test date
$175,000	1.54x	Pass, with a wide cushion
$150,000	1.32x	Pass, with a thin cushion
$141,794	1.25x	Exactly at the covenant
$130,000	1.15x	Breach

The covenant NOI is $113,435 × 1.25 = $141,794. Starting from $150,000 of NOI, a decline of about 5.5% reaches the covenant line. A vacancy, a roof repair that is expensed instead of capitalized, or a property tax reassessment can do that in one year. At $130,000 of NOI the loan payment is unchanged and every payment may have been made on time, yet the borrower is in breach.

The covenant can also interact with the other tests. At $130,000 of NOI the debt yield is $130,000 ÷ $1,400,000 = 9.3%, down from 10.7% at $150,000. If the same loan also had a 10% minimum debt yield, it would fail that test as well, so check every financial covenant against your downside case, not just the one you expect to bind.

Why lenders care

A lender prices and sizes a loan on the property and borrower as they look at closing. Covenants are how it keeps that picture from changing without its knowledge.

• Information: reporting covenants tell the lender about falling income early, while there is still time to act.
• Control of collateral and priority: negative covenants stop other lenders or buyers from coming in ahead of or alongside the lender.
• A negotiating position: a breach gives the lender the right to renegotiate. Even when it does not want to call the loan, it can ask for a fee, a higher rate, a reserve or a paydown before it waives.
• Portfolio consistency: a bank or a CMBS servicer applies standard covenant packages across many loans, which is why some terms are hard to move.

Covenants by loan type

The package changes with the source of capital. Typical patterns:

• Bank and portfolio loans are the most likely to carry financial covenants tested at the borrower or guarantor level, because the lender holds the loan and the relationship. See permanent financing.
• CMBS loans rely more on property-level controls (reserves, cash management, restrictions on transfer and additional debt, single-purpose-entity rules) than on ongoing financial tests, and a servicer has limited discretion to waive.
• Agency loans carry reporting covenants such as annual operating statements. Fannie Mae's Multifamily Selling and Servicing Guide, for example, requires an annual operating statement for each property under its asset management reporting requirements.
• Bridge and construction loans add milestone and leasing covenants, such as completion deadlines, minimum leasing progress and interest or completion reserves (see completion guarantee).
• Mezzanine and subordinate debt brings covenants in the intercreditor agreement that control the order of payments and cure rights.

What happens when a covenant is breached

A covenant breach is usually called a technical default: a breach of a promise other than a payment obligation. It is not the same as missing a payment, but it can lead to the same legal remedies if the lender chooses to use them. The usual sequence is:

1. Notice. Most loan agreements require the lender to give written notice of the breach.
2. Cure period. Many agreements allow a stated period to fix the breach. Some breaches, such as an unauthorized transfer, have no cure right at all.
3. Lender's choice. The lender can waive the breach, amend the covenant, require something in return, charge default interest where the documents allow it, or accelerate the loan and demand full repayment.

In practice, lenders and borrowers usually try to resolve a breach through a waiver, an amendment, a restructured repayment or more time instead of foreclosing. A waiver should be in writing, because an informal conversation or a lender's silence may not protect you. An amendment is documented in a modification agreement. For default in a small-business financing context, see default.

How to negotiate covenants before you sign

Covenants are easiest to change at the term sheet, before you have paid for third-party reports and before the lender's credit committee has set a package. Compare lenders on their covenants, not just on rate and LTV. Ask for the following:

• Cushion in the threshold. Test your downside case. If a 5% drop in NOI trips the covenant, the threshold is too tight for a property with volatile income.
• A cure right for financial covenants. A cure period, or the right to cure by posting cash or paying down the loan, turns a default into a fixable event.
• A consent standard. "Consent not to be unreasonably withheld, conditioned or delayed" is better than a lender's sole discretion. Ask for a stated response period.
• Defined terms that match your books. Check how the loan agreement defines net operating income, debt service and test date. A definition that ignores one-time expenses or uses a stricter vacancy assumption can change the result.
• Permitted transfers. Carve out transfers for estate planning, to affiliates, or among existing partners, so a routine change of ownership does not need consent.
• Reasonable reporting dates. Make sure the deadline in the agreement is one your accountant can meet.

What to watch for

• Calendar the dates. A late financial statement is a breach. Put reporting deadlines, insurance renewals and test dates in a shared calendar with someone other than you.
• Read the guaranty, too. Covenants often sit in the guaranty as well as the loan. A guarantor who falls below a net worth or liquidity covenant, or stops delivering statements, can be in default under the guaranty even when the loan is current.
• Know which covenants survive. A covenant that continues until the loan is paid off continues through any extension option, and many extension options require that no default exists on the exercise date.
• Do not rely on a verbal waiver. Get it in writing and keep a copy with the loan file.
• Talk to the lender early. If you expect a test to fail, telling the lender before the test date usually leaves more options than telling it afterward.
• Non-recourse still has covenants. Breaking certain ones can trigger springing recourse. See non-recourse loans.

Related reading

For how the key ratio is calculated and what lenders look for, read DSCR explained. For the order of payment among lenders, see senior debt. If you are comparing loan offers and want the covenants read alongside the rate and terms, send the term sheets for a review alongside the rate and terms.

Sources: Corporate Finance Institute, "Technical Default"; Fannie Mae Multifamily Selling and Servicing Guide, asset management reporting requirements (annual operating statements); example figures calculated with the BestLoanUSA DSCR calculator at an illustrative rate. Actual covenants depend on the loan documents; this is general information, not legal advice.