Loan Covenants: What do they mean?
Real estate investments often require substantial capital, and securing financing is a common practice among investors. However, lenders need assurances that borrowers will be able to meet their financial obligations – this is where loan covenants come into play. Covenants are essential components of real estate loans, providing a framework for assessing and maintaining the financial health of a project.
Loan covenants are conditions outlined in loan agreements that borrowers must meet throughout the life of the loan, and are designed to protect the interest of both lenders and borrowers. Lenders use covenants to monitor the financial health of the borrower and mitigate potential risks associated with the loan. If the borrower fails to meet these covenants it could trigger default provisions and potentially lead to loan acceleration, repossession or other remedial actions.
Key Covenants
- Loan to Value (LTV)
The Loan to Value ratio is a fundamental metric used by lenders to assess the risk with a real estate loan – it is used across both the residential and commercial market and measures the ratio of the loan amount versus the property valuation.
Example: If a property is valued at £10m and the loan is £5m, then the LTV is 50%. Lenders would then set the LTV covenant slightly higher (say 55% or 60%) to ensure there is a reasonable cushion to allow for some valuation fluctuations. The purpose of this covenant is to make sure the borrower maintains the property value through positive asset management initiatives.
- Interest Cover Ratio (ICR)
The Interest Cover Ratio evaluates the borrower’s ability to cover interest payments using its net operating income. It is calculated by dividing the property’s net operating income by the total interest expense. Depending on the exact terms of the loan, the ICR calculation may include some of the following variations: annualised, 12 month look forward, 12 month look back, contracted net rent, net rent receivable, etc. Always make sure you read the definition of the calculation carefully.
Example: If a property generates £500,000 of net operating income and has £300,000 in annual interest payments, the ICR would be 1.67x or 167%. Lenders typically set a minimum ICR of >1x or >100% to ensure that the property generates sufficient income to meet its financial obligations. Again, this covenant ensures that the borrower is actively managing the property to generate cash flow.
- Debt Service Cover Ratio (DSCR)
The Debt Service Cover Ratio evaluates the borrower’s ability to cover all of it’s debt costs, not just it’s interest payments. It is calculated by dividing the property’s net operating income by the total debt costs (ie. Interest + amortisation). Similarly to the ICR, it can be calculated in multiple ways so it is important to read the definition carefully.
DSCRs are set lower than ICRs (but still >1x or 100%) as there is additional cost to be covered.
- Debt Yield
The Debt Yield is a metric that assesses the potential return on investment or how long it will take a lender to have their loan repaid in case of a default. It’s calculated by dividing the property’s net operating income by the loan amount.
Example: If a property has a net operating income of £400,000 and a loan amount of £4,000,000, the debt yield would be 10%. This means that it will take 10 years for the loan to be repaid. Debt yields are set as a minimum threshold.
These loan covenants are by no means exhaustive, and depending on the borrower, lender, and property, additional covenants or requirements might be introduced to make sure the lender has sufficient comfort that they will get all their money back. They provide a framework for assessing the risk associated with the loan on an ongoing basis. By understanding these metrics and their implications, both borrower and lender can work together to make informed decisions towards successful real estate investments while managing potential risks.
Thank you so much for reading. If you want to know more about loan covenants and how to model them, take a look at our Debt: Loans & Covenants training course, or sign up for our LinkedIn newsletter or join our mailing list for more.