Loan Document Covenant Concerns and Operational Issues in the Age of COVID-19

Sign up for our Coronavirus roundup email.
Visit our Coronavirus resource page.

As the nation engages in social distancing and takes other steps to attempt to slow the spread of COVID-19, players in the commercial real estate space are considering what impacts the virus will have on their business and the steps they can take to mitigate, or at least prepare for, those impacts. With many retail businesses and office buildings closed or operating at a reduced capacity for an unknown (and as of now, unknowable) amount of time, either voluntarily or due to a government mandate, it is apparent that rental streams are in danger of some level of disruption, creating a real possibility of trouble ahead for the owners of commercial properties and the lenders that hold mortgage loans encumbering such properties. Under these circumstances borrowers and lenders will want to examine the documents governing their particular loan(s) to identify the problems that could arise and begin to think of (and perhaps discuss) solutions.

Financial Covenants

The first place that lenders and borrowers should look when examining a loan in the face of COVID-19 is at any financial tests used in the loan documents. Given the reported effects current events are having on cash flows, we expect operating income to be down for most property owners. Downward trending operating income can then trigger certain provisions under loan documents. To discuss a few such covenants and effects:

Some commercial real estate loans contain one or more covenants tied to financial tests, such as debt yields, loan to value ratios (or “LTV”), and debt service coverage ratios (or “DSCR”). 

• Debt Yield - Covenants tied to debt yield tests are likely to be among the first to cause issues. Debt yield is determined simply by looking at the property’s net operating income against the loan amount, and a higher debt yield is intended to indicate a less risky loan.  Reductions in the rental stream will cause immediate and direct reductions in debt yield, which may trip related tests in the loan documents.
• DSCR - Covenants tied to the debt service coverage ratio are also likely to come into play sooner rather than later. Debt service coverage ratios are determined by comparing net operating income to debt service. As with the debt yield tests, higher is better, and reductions in the rental stream will directly cause reductions in a property’s debt service coverage ratio. Of particularly interest for some floating rate loans, recent reductions in interest rates, such as last week’s cut by the Federal Reserve of the 10-year treasury note rate to near zero and LIBOR having its largest one-day drop since October 2008 earlier this month, may somewhat offset the reduction in net operating income (the DSCR numerator) by causing a decrease in the debt service payable on the loan (the DSCR denominator).
• LTV - Somewhat less likely to be immediately tripped by a crisis initially affecting cash flows are covenants relating to loan to value ratios. Value is typically determined by an appraisal, and takes into account both net operating income and capitalization rates.  Therefore, as rental streams decrease, value will go down, but this reduction will often not be immediately determinable given the unclear duration of the COVID-19 countermeasures.   For example, the loan documents may provide that the reduced value will not be realized until an appraisal reflecting such reductions is finalized.  When considering loan to value tests, then, borrowers and lenders should pay attention to what rights the lender has under the pertinent loan documents to order (or require that the borrower order) new appraisals or to otherwise revalue the collateral for the loan.
• Net Worth / Liquidity - Also worth mentioning are net worth and liquidity requirements for guarantors. With respect to some loans, the loan documents will require that guarantors maintain a specified net worth and/or level of liquidity.  Given the level of market volatility caused by COVID-19 and the impact such volatility has had on equity levels, borrowers, guarantors and lenders should review the net worth and liquidity requirements set forth in any guarantees to determine whether additional (or replacement) guarantees or other credit enhancements may be required on this basis.

Effects of Failing to Satisfy Financial Covenants

If a borrower, a property or a guarantor no longer satisfies a financial test, the lender’s rights with respect to such failure will be set forth in the loan documents and those provisions should also be reviewed.   While not intended to be a full list, the following are examples of rights that can be triggered by such failures:

• Cash Management - Certain commercial real estate loans, particularly bridge loans and loans in the CMBS space, provide for a cash management structure to spring into place (or, if in place, to activate) if certain events occur. One of the triggering events for cash management can be the failure of a financial test (usually a debt service coverage ratio test).  However, even if the list of trigger events does not include a financial test, it may include the occurrence of an event of default (which itself may be the result of a failed financial test), so the parties will need to review the covenants in the loan documents (not just in a standalone cash management agreement) to determine whether failing a financial test will result in active cash management. 

If cash management does spring or become activated during these unique times, the parties must consider whether the cash management structure will be manageable.  Has the cash management bank completed its “know your customer” process and opened the account?  If not, are the personnel available at the bank to handle that process?  Will the cash management bank have branches open where the borrower or property manager can deposit rent that they receive?  If rent direction letters are necessary, will there be anyone at the tenant’s notice address to receive the letter?   Even if a lender has the right to impose cash management, they may wish to consider these questions.

• Replacement of Property Manager - In some loans, the lender’s right to terminate a property management agreement or otherwise require that the borrower replace the property manager will be tied to a financial test. For example, the lender may have the right to require that borrower replace a property manager if the debt service coverage ratio drops below a certain threshold (which may be different from the threshold that triggers cash management or other remedies).  Borrowers, lenders and property managers should review any subordinations of management agreements and related provisions in the loan documents to determine whether this will be an issue, and lenders should consider how replacing a property manager due to a decrease in revenue that is likely unrelated to the property manager could be expected to impact the property’s future income stream.
• Replacement of Guarantor - As noted above, the loan documentation may require the guarantor to maintain certain levels of net worth and liquidity. If market instability (whether related to COVID-19 or otherwise) causes the guarantor to fail to meet these tests, then the lender can often require that the borrower put up a replacement (or supplemental) guarantor within a specified period of time, with a default possible for failure to timely do so. 

Other Considerations

• MAC Clauses - Loan documents may contain so-called MAC clauses - clauses which permit the lender to call a default (or pursue a payment guaranty) if there is a material adverse change in the operations or financial condition of the borrower, the ability of the borrower/guarantor to pay its debts, or the value, use or operation of the property. Lenders like these clauses because they provide the lender the ability to pursue remedies when economic conditions, or poor management, are almost certain to lead to the property and/or the loan having trouble in the near future, permitting the lender to realize value in a foreclosure scenario before the value of the property deteriorates materially.  Borrowers and guarantors dislike these clauses because they permit lenders to make subjective determinations about the performance of the loan and the property, as opposed to financial tests which tend to be more objective.  All parties should review the loan documents for MAC clauses, as the presence of such a clause could mean that the parties need to start talking even earlier than they would otherwise, given the fact that rental stream disruptions could trigger a MAC clause even before such disruptions would cause the property to fail an objective financial test, and given the levels of market volatility that have been present for the past few weeks, and the impact such volatility could have on the borrower’s or guarantor’s financial condition.
• Capital Stack - When reviewing their mortgage loan documents, borrowers and lenders will need to be mindful of the existence of any other debt on the applicable property and sure to review the documents for those loans as well. The review may be more complicated if there is any mezzanine debt involved in the capital stack, because when both mortgage and mezzanine financing is present the loan documents will often require aggregating the balances of those loans when calculating debt yield, DSCR, and LTV tests.  Similarly, lenders should review any co-lender or intercreditor agreements to determine the extent to which their ability to offer accommodations to the borrower (or to permit the borrower to offer accommodations to troubled tenants) may be limited by such documents.  Generally speaking, even absent contractual issues, having more parties in the negotiations may make finding consensus more difficult.
• Disclosure - Consider whether the loan documents require that the borrower notify the lender if it becomes aware of the presence of COVID-19 at the property. For example, if the employee of a tenant tests positive, is the borrower required to notify the lender?  Somewhat unexpectedly, the answer may be found in the environmental indemnity agreement (or related provisions of the loan agreement), which will often include microbial matter and airborne pathogens in the definition of Hazardous Materials, and require that the borrower notify the lender of the presence or release of Hazardous Materials which may, in some instances encompass viral infections.   
• Maintenance - Even something as mundane as maintenance covenants may take on a new light in the age of COVID-19. Borrowers and lenders should consider the standard to which the borrower is required to maintain the property - is that standard tied to the maintenance of similar properties in the area?  If so, does that mean that the borrower is required to disinfect the property to the same extent that similar properties in the area are being disinfected?  Does it matter whether positive cases have been identified at another property but not at the subject property?
• Leasing restrictions - Due consideration may need to be given to the possibility that the borrower may desire (or even be required) to make at least short-term uses of certain properties (or portions thereof) to assist with the COVID-19 countermeasures, so it makes sense for both borrowers and lenders to refresh themselves on minimum leasing requirements and related issues under the loan documents.
• Operating covenants - Certain property types (in particular, retail) may have ongoing covenants to remain open during certain hours that will need to be considered in connection with voluntary or involuntary temporary closures that we are seeing in light of the COVID-19 countermeasures.

Next Steps

After having gone through the loan documents and identifying the provisions that could be problematic in the face of COVID-19, what should borrowers and lenders do next?  If any potential problems were identified, the next step should be discussing such potential problems with the other party, and possibly considering a loan modification agreement.  We note that the Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus provides that “[t]he federal financial institution regulatory agencies and the state banking regulators . . . view loan modification programs as positive actions that can mitigate adverse effects to borrowers due to COVID-19.”  The statement also provides that if a loan is otherwise performing, such agencies will not consider “short-term modifications made on a good faith basis in response to COVID-19” to be troubled debt restructurings.

Borrowers and lenders who have gone through their loan documentation, identified potential problems that could be caused by COVID-19 and desire to engage in discussions relating to loan modification should first strongly consider entering into a pre-negotiation agreement to protect themselves and allow for a reasonably free and frank exchange between the parties in trying to formulate a mutually agreeable strategy for working through these unprecedented issues.  Information relating to pre-negotiation agreements can be found here.

These materials have been prepared by Seyfarth Shaw LLP for informational purposes only and do not constitute legal advice.