Loan covenants: what you agree to after closing

A loan does not end at closing. The covenants in the loan agreement set rules you must follow for the life of the loan. A missed covenant can give the lender rights you never expected it to use. Understanding them before you sign is far easier than negotiating them after a problem appears.

What a covenant is

A covenant is a promise in the loan documents. Some promise that you will do something. Others promise that you will not. Lenders use them to watch the credit between closing and maturity and to act early if the property or business weakens.

Most covenants fall into three groups:

• Financial covenants. Tests based on the numbers, such as debt service coverage, leverage, liquidity, or net worth.
• Affirmative covenants. Things you must do, such as deliver financial statements, keep insurance in force, pay taxes, and maintain the property.
• Negative covenants. Things you cannot do without consent, such as add other debt, sell or transfer ownership interests, change management, or pledge the collateral elsewhere.

The financial tests that matter most

Debt service coverage

Many loans require the property or business to produce a minimum level of cash flow relative to its loan payments. The test is often run quarterly or annually. Read how it is calculated. The definition of income, which expenses are included, and whether the test uses trailing or projected figures can all change the result.

Leverage and loan to value

Some lenders test leverage over time, not just at closing. A new appraisal in a softer market can push a loan out of compliance even when the property performs as planned.

Guarantor liquidity and net worth

When there is a guarantee, the lender may require the guarantor to keep minimum levels of cash and net worth. These tests follow the guarantor, not the property. Other investments, distributions, or changes to a family estate plan can affect them.

What happens when a test is missed

A missed financial covenant is not always a default that accelerates the loan. Many documents set out a sequence of remedies first. Common examples:

• Cash management. Rents or revenue flow into a lender controlled account, and excess cash is held until the test is met again.
• Cash sweep. Excess cash goes toward paying down principal.
• Cure rights. The borrower pays down the loan or posts cash collateral to bring the ratio back into line.
• Added cost. Some loans add fees or a higher rate while a breach continues.

Reporting failures are often treated more harshly than people expect. Late financial statements can be a default on their own, even when the numbers are strong.

What to negotiate before you sign

Covenants are usually more flexible at the term sheet stage than at any point later. Areas worth attention:

• Definitions. How income, expenses, and debt service are measured. Clear definitions prevent disputes.
• Testing period and timing. Trailing twelve months is common. Ask when the first test occurs, especially for a property in lease up or a business in transition.
• Cure rights. How many cures are allowed and how each one works.
• Cushion. The gap between realistic projections and the covenant level. A thin cushion leaves no room for an ordinary bad quarter.
• Transfer provisions. Which estate planning transfers, entity changes, or new partners are permitted without consent.

Managing covenants after closing

Treat compliance as a calendar item. Track every reporting deadline and run the financial tests yourself before the lender does. If a breach looks likely, raise it early. Lenders generally have more options, and more willingness to use them, when they hear about a problem from the borrower before the numbers arrive.

If you are comparing loan offers or approaching a test you may not meet, the debt sizing tool can show how much room your current numbers leave. To review a term sheet or loan agreement with us, get in touch.