Navigating CRE Loan Covenants in the Era of COVID-19
You’ve made it to the end of the quarter, and now it’s time to prepare your quarterly financial statements and send them off to your lender. Until recently, you may not have paid close attention to certain provisions in the loan documents (e.g., force majeure, definition of business day, etc.) that may become much more relevant in light of the outbreak of COVID-19 and the economic and societal changes that came with it. Now is the time to dust off those boilerplate provisions to see how they may affect your business and your loan.
The purpose of this alert is to give you something to think about when you interact with your lender in the coming weeks and months as we all adjust to the financial realities in the era of COVID-19. The discussion below outlines some general suggestions and common loan provisions, but it is important for you (or, better yet, your attorney) to review your loan documents, preferably before your next interaction with your lender.
Most loan agreements contain financial covenants, the most common of which is a minimum Debt Service Coverage Ratio, or DSCR, requirement. The Debt Service Coverage Ratio covenant may be formulated in different ways, but generally speaking DSCR is calculated by dividing a business’s net operating income during a given period by the total debt service payments over the same period. The net operating income in the numerator can be determined using various formulas (e.g., it may be determined by subtracting all reasonably necessary expenses from gross earnings, but it may also deduct depreciation, hypothetical capital expenditure reserves and/or other hypothetical costs), and the debt service payments in the denominator may be based on actual payments due or based on hypothetical calculation (e.g., a lender may calculate debt service based on fully amortized loan payments, even during an interest-only repayment period).
Many loan agreements contain a requirement that the product of the DSCR calculation (i.e., net operating income divided by debt service payments) be no less than a certain amount, usually greater than 1. In other words, you need to have positive net cash flow after payment of expenses and debt. If you are facing cash flow deficiencies during this time, it is important to understand exactly how and when your loan documents calculate DSCR and whether there are any opportunities to cure a cash flow deficiency by paying down the loan or otherwise. If you are permitted to pay down the loan, this option may include a prepayment penalty.
There are other common financial covenants, such as net worth, liquidity and debt yield requirements. It is important to understand exactly what your financial requirements are, when they are calculated, where the wiggle room may be, and how best to approach the lender if you expect you may not reach the required thresholds.
Adverse Change Provisions
Many loan agreements (though by no means all) contain what may be referred to as "Material Adverse Change" (or MAC) and "general insecurity" provisions. They generally take one of a few forms: it may be an Event of Default (or other negative consequence for the borrower) if, in the lender’s judgment, (i) a material adverse change occurs in the business or financial condition of the borrower, (ii) the lender believes that circumstances have occurred which will likely impede the borrower’s ability to repay the loan, or (iii) the lender believes itself insecure with respect to the repayment of the loan or value of collateral. These types of provisions are most common in non-real-estate loans (e.g., so-called C&I loans), but they often appear in real estate loans as well, either as an Event of Default or as a situation where the lender may institute a lockbox or other cash management provisions, or cease making advances under a line of credit or construction loan.
You may have seen Sullivan’s advisory regarding the recently enacted CARES Act, which, among other things, makes available SBA loans to small businesses (generally not more than 500 employees) to help bridge the financial gap during the current crisis. Although this may be an appealing option to many of our clients, most loan agreements for existing financing prohibit incurring additional debt outside of the ordinary course of the borrower’s business (usually limiting you to things like payroll and trade payables). Borrowing under this new SBA program could, therefore, trigger a default of your existing mortgage loan. It is important to reach out to your existing mortgage lender before you get too far in the SBA loan process to make sure the lender will allow the new loan. Many institutional mortgage lenders are also approved SBA lenders, so you may be able to kill two birds with one stone.
Lease and Contract Provisions
Most real estate loan agreements or ancillary loan documents (such as the mortgage or assignment of leases and rents) contain prohibitions and requirements with respect to leasing. In many cases, certain amendments to leases, such as shortening the term, forbearing from collecting rent, or reducing the rent amount, are prohibited (without lender’s consent) in the landlord’s loan documents. In addition, the borrower-landlord may not be permitted to enter into new leases unless the term and rent provisions meet certain minimum requirements. These prohibitions also often apply to management agreements and other key/material contracts required for the ongoing operation (or development) of your property. Keep these requirements in mind if you are negotiating with tenants, vendors or service providers who may be facing financial difficulty.
Construction Loan Considerations
There are a number of provisions that are unique to construction loans that may be of concern, given that many construction projects have been put on hold during this time or that construction may be proceeding with less efficiency in light social-distancing requirements. Most construction loan agreements contain provisions requiring that development and construction proceed without delay in accordance with a project schedule. Most also require that the project be completed by a particular date. There may be certain exceptions to these requirements, such as so-called “force majeure” exceptions, but it is important to read these exceptions carefully to determine if the current circumstances allow you to take advantage of the exception. Most loan agreements also require that the borrower provide timely notice of a work stoppage or force majeure event in order to be able to take advantage of the exceptions. Similar to the leasing provisions discussed above, construction loan agreements also usually prohibit modifying construction and development contracts without the lender’s consent.
In addition to the requirements and convents discussed above, loan agreements generally require the borrower to send written notice to the lender upon the happening of certain events. These often include providing notice of a material adverse change or material adverse event, and the requirement to notify the lender if any type of default has occurred under the loan. As noted above, you may also be required to provide the lender with notice that a work stoppage or force majeure event has occurred, or if a tenant has defaulted under a lease. Read your loan documents carefully (or have Sullivan read them for you) to determine exactly when and how you are required to give notices to your lender.
Representations and Warranties
In addition, since many borrowers are getting ready to submit quarterly financial statements, it is important to note that many loan agreements provide that the submission of a periodic financial statement (or a request for a loan advance) is deemed to be a restatement of certain representations and warranties contained in the loan documents. This has the potential to create an indirect default, not because you breached a particular covenant, but because you were deemed to remake a representation that was not true. Again, it is important to read the loan documents carefully to make sure that there have been no changes in circumstances in connection with a representation that is deemed remade.
Most borrowers understand that if they don’t make their mortgage payments, it is a default under the loan. But failure to observe the other covenants, many of which are discussed above, can also result in a default, even if you continue to make your monthly debt service payments. So, what does all of this mean, and what is the result if a financial covenant is breached or you need to provide notice of a material adverse change or work stoppage?
The most straightforward possible result is that a breach of the loan documents (including the types of provisions outlined above) may result in an Event of Default, entitling the lender to call the loan and foreclose the mortgage. But there are also less drastic (but nevertheless concerning) possibilities—the lender may put you into a workout scenario in which it takes a more direct interest in the day-to-day operations of your business. Covenant breaches may also preclude you from extending the loan’s maturity, allow the lender to stop permitting draws on a line of credit or construction loan, or maybe you will need to start escrowing taxes and insurance payments or go into a lockbox arrangement.
Now is the time to review these issues as they relate to your commercial real estate loans. Dotting your "i’s," crossing your "t’s" now, and coming up with a strategic approach to communicating with your lender, may save you aggravation, uncertainty and expense in the long run.
Sullivan has developed a rapid response team of attorneys to help our clients and our communities cope with the impact of the COVID-19 pandemic. Please refer to Sullivan’s resource center at sullivanlaw.com/COVID19 for more information and for access to Sullivan’s library of related advisories.
Please know that Sullivan is focusing substantial efforts to provide assistance to businesses and individuals affected by COVID-19. If you have questions about how to move forward and navigate the novel legal issues raised by COVID-19, please contact your primary Sullivan attorney or send a message to CARES@sullivanlaw.com.