Understand the fine print in a commercial mortgage

By ,
Ask a Lender
September 21, 2017


Key Points

Abut commercial loan covenants

  • Loan covenants exist to protect the interest of the lender
  • Restrictive covenants dictate or set restrictions on certain business operations
  • Financial covenants set standards for balance-sheet performance indicators, such as the debt-service coverage ratio.
  • Loan covenants can be negotiated with a lender

There's more to commercial mortgages than just establishing the size of your loan, determining its length and interest rate and keeping up with your monthly payments.

Many commercial loans, especially those considered to be high-risk, come with requirements designed to assure the future health of your business as well as stipulations focused on how the business is managed. If the requirements aren't met, you can be considered in default on your loan, even if payments are up-to-date.

The requirements are known as covenants, or promises, that are in effect over the term of the loan. They're not unlike the provisions of residential mortgages or auto loans that require borrowers to keep their financed property insured.

But in commercial mortgages, the covenants are more extensive. They range from relatively simple requirements that give lenders access to a company's financial information, to much more onerous restrictions granting lenders veto power over any significant financial decision.

Some covenants require borrowers to do certain things; others limit what borrowers can do. Some are strictly related to financial performance; others govern who owns and runs a business during the term of a loan.

They are the fine print of commercial mortgages that, in the words of the Small Business Finance Institute (SBFI), "can put constraints on a business's growth, increase the overall cost of a loan and raise business risk."

Covenants exist to protect the interests of lending institutions, and those institutions have no greater interest than making sure the loan will be paid back. To that end, covenants may require that borrowers put up some portion of their personal assets as collateral, or that a spouse cosign a commercial mortgage agreement — a potentially messy requirement in the event of a divorce.

Beyond those sorts of personal-guarantee requirements, commercial loan covenants fall into two broad categories: Restrictive covenants and financial covenants.

Restrictive covenants

It's the restrictive covenants that dictate — or restrict — the operation of a business. The lending institution presumably liked your business' management structure when it agreed to finance your commercial mortgage. Loan covenants may require the lender's approval if you try to change that structure or bring in management consultants for advice.

Similarly, your company had certain assets that the lender valued when you applied for your loan. Under common covenants, it's the lender's call when you consider selling or otherwise transferring ownership of those assets.

"You may be forced to hold onto underperforming assets to satisfy these covenants and lower the returns on your capital," the SBFI warns.

Some covenants spell out the consequences of conflicts with the IRS and other tax collectors. If there's a tax lien placed on any of the assets you pledged as collateral, the lien could trigger a loan default even if the dispute is eventually resolved in your favor.

If your business is making money, you might want to reinvest the profits in the company or perhaps, issue a dividend to investors. Pay close attention to your loan covenants, they may require that you clear those actions with your lender.

Financial covenants

Financial covenants are different than the financial terms of the loan. They require measurements of how your business is performing financially and whether it's likely to be able to keep making commercial mortgage payments during the term of the loan. The measurements are usually reported to lending institutions quarterly.

Three common financial covenants measure a company's debt-service coverage ratio (DSCR), its debt-to-worth (or leverage) ratio and its working capital, according to the financial management company Wilmington Trust.

The DSCR indicates your ability to service your debt. It's calculated by dividing your company's net cash flow by the cost of the company's debt service. Wilmington Trust says lenders typically require a DSCR of at least 1.20 — or net-cash flow of at least $1.20 for every dollar of debt service required.

The debt-to-worth ratio is calculated by dividing a company's liabilities by its shareholder value. If a company's total liabilities are twice the shareholder equity in the company, its debt-to-worth ratio is 2 to 1.

When a lender drafts a working-capital covenant, it will set a benchmark based on the sum of a company's current assets — including cash, accounts receivable and inventory — minus its current liabilities. "A minimum working-capital covenant ensures that the borrower exercises prudent balance-sheet management and maintains adequate flexibility to meet interim cash needs," according to Wilmington Trust.

Negotiations, reporting essential

Covenants, like other parts of a mortgage, are subject to negotiation, something many borrowers don't realize, or forget.

"Some finance professionals first see covenants when asked to sign the loan documents, but they have had no preliminary discussions and believe that covenants are a one-sided dictation from the bank," an article in the Journal of Accountancy explains. "In general, this is not true. Although certain covenants must be expected in a commercial loan, a knowledgeable CPA should effectively negotiate fair and reasonable covenants."

Negotiations are possible even after you sign the mortgage papers. If your company runs into financial impediments that could violate a loan covenant, let your bank know quickly, and try to reach an accommodation.

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