Covenant
A covenant (loan condition) is a term in a loan agreement that the borrower undertakes to comply with throughout the life of the loan. In property finance, covenants are the lender's most important tool for monitoring risk after the loan has been paid out: if the borrower breaks a term, a breach arises that gives the bank the right to act, even if interest and principal have been paid as agreed.
Covenants are usually divided into two groups. Financial covenants relate to key figures and are measured on an ongoing basis, typically each quarter. The most common ones in property are an upper limit for loan-to-value ratio (LTV, for example "max 65%"), a lower limit for debt service coverage ratio (DSCR) and a lower limit for interest coverage ratio (ICR). Non-financial covenants govern behaviour: a ban on taking on new debt with priority, a requirement to keep the property insured, a limit on dividends, or a requirement to inform the bank if a major tenant is lost or there is a material change in the property company.
A breach of a covenant does not automatically trigger termination. Most often the bank and the borrower negotiate: a temporary waiver, repayment to bring the key figure back below the limit, a higher interest rate or additional security. But a breach shifts the negotiating power to the bank, and in a falling market where the valuation pushes LTV upwards, several borrowers may breach the LTV covenant at the same time without having done anything wrong in their operations. The covenant margin is therefore read as a measure of how much market turbulence a financing arrangement can withstand.
For an investor, the covenant structure is part of the risk picture when buying a leveraged property or a share in a property syndicate. Tight covenants give a lower interest rate but less room to manoeuvre; generous covenants cost more but give flexibility in a downturn. In a due diligence review, all covenants in existing loans are therefore examined, together with when they are measured, what margins exist, and what happens in the event of a breach. A property with a good yield but strained covenants may be a greater risk than the other figures suggest.
From Placepoint's dictionary: Covenant
More information: Store norske leksikon: covenant, Finanstilsynet
English: Loan covenant.
Frequently asked questions
What is a covenant?
A covenant is a term in a loan agreement that the borrower must comply with throughout the life of the loan. In property finance, the bank uses covenants to monitor risk after the loan has been paid out. A breach gives the bank the right to act even if interest and principal are paid as agreed.
What are the most common covenants in property loans?
The financial covenants are usually an upper limit for loan-to-value ratio (LTV), a lower limit for debt service coverage ratio (DSCR) and a lower limit for interest coverage ratio (ICR). In addition, there are requirements on insurance, dividend limits and a duty to provide information.
What happens if a covenant is breached?
A breach does not automatically trigger termination. The parties usually negotiate a temporary waiver, repayment, a higher interest rate or more security. Even so, the breach shifts the negotiating power to the bank.
Why can several borrowers breach the LTV covenant at the same time?
Because LTV is measured against the valuation. In a falling market, LTV rises as values fall, and many borrowers can breach the limit at the same time without any change in operations. The covenant margin is therefore a measure of how much market turbulence the financing can withstand.