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3.15.1 Balance Sheet Covenants

Under balance sheet covenants, the clause is based on individual or consolidated balance sheets, usually with reference to the past performance of the main economic and financial parameters of the borrower company and/or its sponsors (in cases involving SPVs) and setting out “red lines” in order to ensure that the assets and financial structure of those entities remain compatible with the level of debt taken on.

Balance sheet covenants include commitments on the part of the borrower company to maintain for the full term of the loan:

• a net balance sheet capital level which is not lower than a specified minimum;

• the ratio of total indebtedness to net capital within a given limit;

• a current liquidity indicator which is not lower than a specified minimum;

• financial charges within a specified percentage limit of turnover.

3.15.2 Financial Covenants

Financial covenants are closely related to the real estate transaction being financed. The following financial ratios are those most commonly used in the aforementioned covenants.

Interest Cover Ratio[1] (ICR) is the ratio between the operating income,[2] the income gained from the lease and/or sale of the properties, and the amount of interest due to the bank on the loan over the same period.

Depending upon the type of property, this ratio may exceed 120-170%. If the ratio is lower than this, but still higher than 100%, the bank may activate other guarantees, request the provision of equity, or withhold all assigned rental payments (known as a “Cash Sweep” clause[3]) until the ratios have been re-established. A figure below 100% will result in an event of default, since the interest due on the loan will no longer be covered by the operating income.

Debt Service Cover Ratio (DSCR) is the ratio between the operating cash flows gained from the lease of the properties and the amount of the instalments (principal and interest) due to the bank on the loan over the same period. Depending upon the type of property and the financial structure of the transaction, this ratio must at all times exceed 120-140%. Below this ratio the arrangements applicable to the ICR apply.

Loan to Value Ratio (LTV) is the amount of the loan granted or the residual amount due to the bank as a percentage of the OMV of the property at the time the indicator is calculated. Depending upon the type of property and their risk, this ratio must not exceed 60-80% of the value of the properties (although for mezzanine financing may be as high as 90%); obviously, these percentages vary over time in line with market conditions. In the event that the limit is breached, the borrower must reduce the loan in order to restore the agreed LTV, and if it fails to do so, the bank may terminate the agreement.

Loan to Cost Ratio (LTC) means, at any given time, the amount of the loan granted or the residual amount due to the bank by the borrower as a percentage of the construction cost of the property at the time it was calculated. Depending upon the type of property, this ratio must not exceed 60-70% of the construction cost of the properties (although for mezzanine financing may be as high as 80-85%). In the event that the limit is breached, the borrower must reduce the loan in order to restore the agreed LTC, failing which the bank may terminate the agreement. This ratio is usually used to regulate drawdown amount in construction financing rather than being used as a covenant.

It is a straightforward matter to render changes to the financial terms of the loan conditional upon these ratios: an increase in ICR and/or DSCR and/or a fall in LTV/LTC may result in a reduction in the spread for the transaction (and vice versa).

Yield on Debt means, at any given time, the net rental payments relating to the property financed as a percentage of the amount of the loan due by the borrower to the bank at the same time (Net Operating Income/Loan amount). For bullet financing arrangements, an exit yield on debt clause may be inserted specifying the minimum ratio which must apply upon maturity of the loan (Net Operating Income/Loan amount after ... years' loan term).

Project Cover Ratio (PCR) means the present value of cash flows for the entire lifetime of the project as a portion of the present value of the debt. This makes it possible to assess the capacity of the cash flows generated to repay the debt over the entire lifetime of the project, thus also including the period after that stipulated for repayment. In order to be satisfactory it must be higher than 1, and the higher that value, the greater protection will be provided to lenders, given the financial solidity of the project. On the contrary, the borrower will attempt to maintain its value as close to 1 as possible in order to maximize the use of financial leverage.[4] However, it is not possible to define a standard absolute value, as the banks also take into account other qualitative factors. Moreover, its significance is limited since the level of this ratio may depend upon the cash flows generated after the repayment period specified in the loan agreement has ended.

Loan Life Cover Ratio (LLCR) means the present value of cash flows between the date of valuation and the deadline for repayment of the debt and the residual (or outstanding) debt on the date of valuation. This ratio will be meaningless before the property has entered its operational stage. However, it is more useful than the previous ratio (PCR) since it focuses its analysis exclusively on the cash flows generated during the period specified for repayment of the loan. This ratio should also be higher than 1 in order to ensure that the loan is repaid in accordance with the repayment plan specified, whilst at the same time leaving funds available to remunerate shareholders.

The last two ratios are predominantly used in infrastructure project finance deals rather than properties.

A simple numerical example describes the procedure for calculating some of the covenants presented above.

EXAMPLE 3.4

A property currently valued €1,000 is leased and generating cash flows of €70/year. OMV as well as real estate cash flows are assumed to increase by 2% per annum, therefore keeping the property yield constant at 7%, The financing agreement states a different interest rate according to the LTV over time (6% when LTV is above 45%, 5% otherwise), decreasing due to a fixed repayment plan. Calculations for LTV, ICR, DSCR, and Yield on Debt are reported in Figure 3.7.

The following is an example of a financial covenants clause.

LOAN TO VALOE

• The Borrowers must ensure that the Loan to Value does not, at any time, exceed ...%.

• If the Borrowers are not in compliance with paragraph ..., they shall have a period of ten business days to remedy such breach by either:

• prepaying the Loans in the amount which would, upon such prepayment, result in the Borrowers being in compliance with paragraph ...;

• depositing the amount referred to in paragraph ... into the cure account.

• The Bank shall, provided no default is then outstanding, transfer any amount credited to the cure account pursuant to this sub clause together with interest accrued thereon to either general account (in accordance with the instructions of the Borrowers) once the Borrowers are in compliance with paragraph ... above without taking that amount into account.

INTEREST COVER RATIO

• The Borrowers must ensure that Interest Cover is, as at each Interest Payment Date, equal to or greater than

• If the Borrowers are not in compliance with paragraph ..., they shall have a period of ten business days to remedy such breach by:

• prepaying the Loan in the amount (calculated by the Bank) which, taking into account the resulting reduction in the projected annual finance costs (as defined

Property Market Value

€ 1,000

Annual MV increase

2.00%

Property Yield

7.00%

Initial LTV

65.00%

Maturity (years, max 35)

20

LTV treshold

45.00%

Interest rate

Under LTV

Above LTV

5.00%

6.00%

Examples of financial covenants

FIGURE 3.7 Examples of financial covenants

in the definition of Interest Cover), would result in Interest Cover being at the minimum level required under paragraph or

• depositing into the cure account the amount (calculated by the Bank) which is equal to the amount by which projected annual rental (as defined in the definition of Interest Cover) was less than the level necessary for the Borrowers to have been in compliance with paragraph ... on the relevant Interest Payment Date.

• The rights set out in paragraph ... (the Cure Rights), taken together, may not be exercised by the Borrowers more than six times prior to the final maturity date or on more than two consecutive Interest Payment Dates. For these purposes, each time an amount credited to the cure account under paragraph ... is taken into account for the purposes of paragraph ... (irrespective of whether a further deposit is made to the cure account) constitutes the exercise of a cure right.

• The Bank shall, provided no default is then outstanding, transfer any amount deposited in the cure account pursuant to this sub clause together with interest accrued thereon to either general account (in accordance with the instructions of the Borrowers) on the expiry of two consecutive Interest Periods commencing on the first Interest Payment Date to occur (following the date of such deposit) upon which the Borrower is in compliance with paragraph ... without taking that amount into account.

YIELD ON DEBT

• The Borrowers must ensure that the Yield on Debt, on each Interest Payment Date occurring on or after the fourth anniversary of the date of this Agreement is not less than ...%

• If the Borrowers are not in compliance with paragraph ..., they shall have a period of ten business days to remedy such breach by:

• prepaying the Loans in the amount which would, upon such prepayment, result in the Borrower being in compliance with paragraph ...;

• depositing the amount referred to in paragraph ... into the cure account.

• The Bank shall, provided no default is then outstanding, transfer any amount credited to the cure account pursuant to this sub clause together with interest accrued thereon to either general account (in accordance with the instructions of the Borrowers) on the expiry of two consecutive Interest Periods commencing on the first Interest Payment Date to occur (following the date of such deposit) upon which the Borrowers are in compliance with paragraph... without taking that amount into account.

  • [1] Also known as Interest Coverage Ratio.
  • [2] In cases involving the financing of hotel operations in which the hotel operator is also the owner of the property, the relevant cash flow is calculated as the difference between total earnings and the sum of all operating costs, provisions for Furniture, Fixtures & Equipment, and the management fee, according to the Uniform System of Accounts for the hotel industry.
  • [3] A Cash Sweep clause is a provision according to which, in the event that one or more financial covenants (ICR, DSCR, LTV) are not complied with, the borrower must repay the excess amount of the loan and/or provide supplementary guarantees approved by the Bank to satisfy the covenants. A typical request is the use of excess free cash flow generated by the transaction in order to reduce the outstanding debt amount.
  • [4] On the role of leverage in a real estate portfolio please see Anson and Hudson-Wilson (2003).
 
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