The Call for Effective Covenant Monitoring Has Never Been Louder

In the world of commercial lending, banks and borrowers are paying close attention to their financial covenants. And for good reason: covenants enforce minimum financial performance conditions on the borrower. These loan covenants are not a pre-decided set of principles that are applicable uniformly across transactions. Covenant structures usually change based on the type of borrower, such as the sector engaged in, geographical presence, risk faced by the borrower and nature of the facility. 

There are many types of loan covenants, but covenants used in commercial lending are more complex given the business operations and finances are more nuanced in a large commercial deal. For example, a commercial loan covenant may require the borrower to provide an accounts receivable listing monthly. There are financial covenants, which we’ll dive into below, as well as non-financial covenants, such as prohibiting a borrower from changing ownership of their company without written consent from the lender. 

Regardless of the type, the covenants provide early warning of potential issues with borrowers. Therefore, they serve both as a communication tool and as a control mechanism. Understandably, covenants can also be difficult for banks to manage, especially given higher interest rates, ongoing CRE challenges and other economic shifts. It can be tough to meaningfully track and analyze various covenants across a commercial portfolio when covenants are housed in different systems and spreadsheets. 

This blog will outline key financial covenants and the importance of effective covenant monitoring, as well as some best practices that lenders can apply to their own processes. 

Key Financial Covenants for Lenders

The following are some of the most important financial covenants for lenders:

Loan to Value (LTV):

This fundamental metric is used to assess the risk associated with a real estate loan. It measures the ratio of the loan amount to the appraised value of the property. For example, if a borrower is seeking a loan of $500, 000 for a property appraised at $1 million, the LTV ratio would be 50%. Lenders often set a maximum LTV ratio to ensure that borrowers have a reasonable equity cushion and are less likely to default if the property's value declines. For commercial loans, the figure is around 70%, though the figure varies widely depending on the type of property.

Interest Coverage Ratio (ICR):

This evaluates the borrower's ability to cover interest payments on the loan using its net operating income. It's calculated by dividing the property's net operating income by the total interest expense. A higher ICR indicates that the property's income exceeds its interest obligations. A minimum ICR helps ensure that the property generates sufficient income to meet its financial obligations. Given the sharp rise in interest rates in the last year, ICR covenants are especially important to monitor. 

Debt Yield:

Debt yield assesses the potential return on investment for a lender in case of default and is calculated by dividing the property's net operating income by the loan amount. This metric provides insight into how well the property's income can cover the loan amount. For example, if a property has a net operating income of $500,000 and a loan amount of $2 million, the debt yield would be 25%. Establishing a minimum debt yield helps ensure that even if the property value declines, the bank would still recover sufficient collateral.

A Better Way to Manage Covenants

Strong, enterprise-wide risk management requires efficient covenant monitoring. Given the uncertainties that remain in the CRE space, it’s worthwhile for banks to consider an early warning system that automatically identifies deterioration in commercial loan covenants.

Covenant monitoring and exception tracking tools, like Baker Hill NextGen® use internal triggers to notify loan officers when a covenant is at risk of falling out of compliance. This proactive approach equips loan officers to engage in meaningful conversations earlier, as opposed to when the covenant has been breached. In many cases, once a covenant has been breached, it may be too late to take remedial action, which means conversations and negotiations with clients can become contentious.

Internally tracking covenants and any other policy exceptions with automated tools leads to more desirable results for both the bank and borrower. When spreadsheets are used to manage these items, hidden risks may not appear until it’s too late. Nobody likes surprises, especially banks. This approach to covenant monitoring helps reduce surprises and mitigates exposure to risk while making it easier for banks to ensure borrowers fulfill their loan obligations.

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