A covenant is a binding provision in a commercial real estate loan agreement that requires the borrower to meet specific financial or operational conditions for the life of the loan. The most critical are financial performance covenants, minimum DSCR, maximum LTV and minimum debt yield, which the lender tests periodically against the property’s actual operating performance.
What types of covenants appear in CRE loans?
Affirmative covenants are things the borrower must do, such as maintain insurance or provide annual financial statements. Negative covenants are things the borrower must not do, such as take on additional debt or sell the property without lender consent. Financial performance covenants set the thresholds: a minimum debt service coverage ratio, a maximum loan-to-value ratio or a minimum debt yield.
Breaching a covenant triggers penalties, cash sweeps, lock-box provisions or a default event. Failing a test does not always mean the loan is in default; many loans include cure periods or allow the borrower to post additional collateral. You have to know what the documents say before the test fails.
Why is covenant compliance hard to manage?
Covenant compliance is one of the most operationally intensive parts of managing a CRE debt portfolio. Each loan carries different covenants, testing periods (monthly, quarterly or annually), NOI definitions (T-3, T-6 or T-12) and cure provisions. A DSCR covenant tested on a trailing three-month basis produces very different results from the same covenant tested on trailing twelve months, especially for properties with seasonal income patterns.
How covenants show up in LoanBoss
LoanBoss abstracts covenant provisions from over 6,000 loan documents, tracks test dates and automates the compliance calculations with each lender’s adjustments, so borrowers and lenders always know where they stand.
Frequently Asked Questions
What is the difference between an affirmative and a negative covenant?
An affirmative covenant requires an action, such as maintaining insurance or delivering annual financial statements. A negative covenant prohibits one, such as taking on additional debt or selling the property without lender consent.
Does breaching a covenant put the loan in default?
Not always. Many loans include cure periods or allow the borrower to post additional collateral before the breach becomes a default event.
How often are financial covenants tested?
It depends on the loan: monthly, quarterly or annually, using the NOI definition (T-3, T-6 or T-12) the documents specify.
Related Terms
- Debt Service Coverage Ratio
- Debt Yield
- CMBS
- Escrow
- Loan Abstract
- Recourse and Non-Recourse Loans
- Balance Sheet and Bank Loans: Covenant Tracking for Real Estate Owners
- CRE Loan Covenant Compliance Software Compared: Borrower Tools vs Lender Tools
Part of the LoanBoss CRE Debt Glossary. For hedging-specific terms, see Pensford’s resources.
Sources
- LoanBoss CRE Debt Glossary