Loan financing is a cornerstone of real estate development. It’s a rare project that has captive capital to finance the entire project, and many investors expect that their contributions will be leveraged with debt financing.
Not surprisingly, lenders will not simply give away money with no strings attached. Although setting interest rates and repayment terms will always be the core of the negotiation, lenders require much more than timely payment from their borrowers.
Construction Loans
In a construction loan, lenders will require that certain actions be taken and milestones achieved within set periods, that costs align with a lender-approved budget, and that the project be operational by a drop-dead date.
Although plenty of developers have sophisticated and supportable models for their projects, unanticipated market changes, such as increasing cost of materials or high demand for labor, can dramatically undermine a budget and timeline – even those that were conservative at the time they were prepared. Accordingly, developers should build comfortable buffers into their forecasts and be firm in the need for those buffers when negotiating budget and timing covenants.
In addition, construction loan lenders often require certain conditions to be achieved before the lender will make loan disbursements. These conditions may include, among other things, providing lien waivers from all contractors working on the project and certifications from third parties that the work performed has been in accordance with the lender-approved development plan. To minimize the risk of construction delays, it is critical that borrowers be prepared to handle the administrative burden that these requirements impose. Further, borrowers should confirm that their selected contractors, architects, and engineers will be able to provide documentation that satisfies the lender’s requirements. Notwithstanding that the parties are all generally anxious to get a project started, having these conversations before executing the loan documents reduces disagreements and stress down the road.
Financial and Operational Covenants
In addition to the value of real estate under development and the ultimate value of the project, a lender’s ability to underwrite a project depends on the project’s anticipated financial performance. Accordingly, lenders often require their borrowers to achieve and maintain certain financial and operational benchmarks that give the lender comfort that the project will support repayment of the loan.
Two common financial covenants require the borrower to (1) achieve and maintain a minimum debt service coverage ratio (DSCR), which is the ratio of the borrower’s net operating income or EBITDA to its scheduled loan payments, and (2) achieve a minimum debt yield, which is the borrower’s net operating income or EBITDA divided by the principal balance of the loan. Particularly for development projects, borrowers need sufficient time for the project to ramp up and mature before the borrower is required to maintain a high DSCR or debt yield.
Lenders often impose additional performance covenants that are tailored to the project and, if missed, indicate that the project’s financial performance will eventually fail to satisfy lender expectations. In multi-tenant housing, for example, borrowers are often required to achieve minimum occupancy rates. In other industries, covenants may require that the project achieve and maintain certain production levels. Although it’s understandable that lenders would want to anticipate poor financial performance before borrowers becomes unable to pay debt service, borrowers are frustrated when they find themselves in default notwithstanding that they have made all required payments and satisfied their financial covenants.
Monitoring Covenants
To track the borrower’s performance and confirm comfort, lenders require periodic reporting from the borrower of its financial and operational performance. Although most sophisticated development teams are more than capable of satisfying these reporting requirements, it is not uncommon for borrowers to find themselves annoyed or panicked when they undertake these reporting requirements and realize the administrative cost they impose.
Covenants Matter – Timely Payment Is Not Enough
We recognize that some reading this article may think “as long as we make timely payments, satisfying these additional covenants shouldn’t matter.” Unfortunately, these covenants do matter, and lenders have increasingly focused on these additional covenants and demonstrated their willingness to act on noncompliance.
Financial institutions are businesses that make money in a variety of ways. Borrowers should not presume that their lenders will be satisfied with fees paid at the origination of the loan and interest earned over the life of the loan. In fact, many lenders measure the success of their teams based on the additional fees and penalties they extract from their borrowers.
In addition, lenders often leverage a borrower’s failure to satisfy its covenants to force the borrower to modify their loan terms to the lender’s benefit. A default from the borrower could trigger penalties, repayment, or other damages. Although lenders are often willing to forbear on pursuing these remedies, they require an exchange of value from the borrower, such as payment of additional fees, increasing the interest rate, or the borrower shouldering additional obligations that will make the lender more money over the life of the loan. Making timely payment is essential – while failure to do so is the quickest way to end up in hot water with a lender, it is not the only way.
Borrowers need to be conservative when negotiating covenants with their lender. Rather than acquiesce to lender proposals or accept the documentation provided as “standard terms,” borrowers should carefully consider how likely it is that they can achieve the lender’s requirements and whether they might need additional time to ramp up performance. Borrowers should also consider negotiating the right to cure a technical default in a way that remedies the lender’s concerns, such as the borrower’s owners making additional capital contributions to shore up the borrower’s balance sheet. A little flexibility and wiggle room can go a long way.
