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Art of the Covenant 

Best Practices for Minimizing CRE Borrowing Risk

By on Apr 10, 2023 in News

Covenants – agreements between a debtor (borrower) and creditor, or lender, are a staple of commercial real estate loans. Designed to reduce risk for lenders, loan covenants commit the borrower to execute certain behaviors, such as making principal and interest payments when due, and avoid others, such as selling the assets that underpin the loan without first repaying it in full. 

Certain economic conditions – falling portfolio values, high operational expenses, rising vacancy rates – increase the risk of violating, or breaching, a loan covenant, by being late on payments or reporting or by failing to meet financial benchmarks. 

One example of a covenant breach is a CFO missing a debt service ratio, which measures the cash flow available to pay current debt obligations. That could result in the lender calling the loan, forcing the company to obtain financing to repay the called loan. 

Avoiding such a scenario requires transparency in lender requirements, deep understanding of the factors that influence debt such as forecasts and rents. “Covenant tracking is a big trend now. On the borrower side, the emphasis is on transparency and getting insight into debt portfolios,” observes Chris Barbier, senior manager of investment management for Yardi. 

How can borrowers minimize risk and maximize efficiency in managing their loan covenants? One of the most reliable ways involves using one technology platform rather than multiple systems for loan, asset management and investment activities. 

“If you’ve got an operating property – which is usually the collateral for the loan in a system – and then you’ve got loans being tracked somewhere else, the two processes are not aligned. A tightly integrated solution allows for better transparency and risk management,” Barbier says. 

A single technology system that centralizes all loan information and automates processes helps borrowers by: 

  • Ensuring deliverables are sent to lenders. 
  • Monitoring the compliance status of key covenants. 
  • Tracking and accounting for different types of loans 
  • Tracking changes in loan terms over time and their impact on the amortization schedule. 
  • Providing full visibility into asset operational performance such as loss of income and deterioration in asset values, making it easier to anticipate and deal with potential problems. 
  • Reducing manual errors by eliminating spreadsheets. 
  • Providing full visibility and an audit trail into payment history. 

Most importantly, such a system “provides a single source of truth. That means transparency from the investment to how the loan and underlying collateral are performing,” Barbier says. 

Learn how Yardi Debt Manager enables tracking and accounting for a loan portfolio and provides visibility into debt obligations with the underlying operating assets.