As the fallout from the COVID-19 pandemic continues, social distancing and remote work protocols continue to impact the commercial real estate industry. Many mortgage lenders provided loan modifications or deferral of mortgage payments at the beginning of the pandemic as a courtesy to their customers, but a second modification will likely be much more difficult to obtain for commercial real estate investors. As investors apply for additional modifications or deferrals, banks may require a new appraisal of the real estate and may even reevaluate the covenants and borrower’s requirements in the loan document. Unfortunately for commercial real estate investors in majorly impacted industries, such as hotels or retail businesses, a bank may at that point determine it best to reduce its exposure in those sectors, leaving investors searching for a new lender.
Steps to Take Before Requesting a Loan Modification
Prior to requesting a loan modification or deferral of payment, an investor should examine their loan document to determine if certain covenants are impacted by a loss of value or cash flow. A lost tenant and a lack of alternative tenants could result in the value of an investor’s buildings declining. While at the same time, existing tenants experiencing cash flow issues may result in missed or delayed rent payments, which could significantly impact the investor’s cash flow. These occurrences could affect common commercial real estate covenants—which are likely in your loan agreement—and are as follows:
Covenants Tied to Cash Flow
Reductions in net operating income or cash flow due to delayed or missed rent payments can cause reductions in the following ratios, which could lead to covenants not being met:
- Debt Yield Ratio – Debt yield compares the property’s net operating income against the loan amount. A high debt yield ratio typically indicates a less risky loan, while a low debt yield, either due to low net operating income or high loan balances, can indicate a more risky loan.
- Debt Service Coverage Ratios – Debt service coverage ratios compare net cash flow after payment of expenses and debt-to-debt service. Debt service consists of principal and interest payments on existing mortgage loans.
Covenants Tied to Appraisal Value
The impact of COVID-19 on real estate values is largely unknown at this point in time, but reductions in appraised real estate value due to a lost tenant or lack of demand for the property could lead to the following covenants not being met.
- Loan-to-Value Ratio – This ratio examines the relationship between the principal balance of the loan and the value of the real estate securing the loan. To the extent the value of the real estate has declined, but the loan amount has remained consistent, the loan-to-value ratio will decline. In this situation, an equity injection may be required from the real estate investor in order to meet the loan-to-value covenant.
- Net Worth/Liquidity – Certain loan documents require the guarantor to maintain a specified net worth and/or level of liquidity. To the extent the guarantor’s liquid assets or net worth have declined during the pandemic, it may cause issues with net worth or liquidity requirements included in loan documents.
If your commercial real estate investments have been impacted by the COVID-19 pandemic, now is the time for you and your advisors to review your loan documents and develop a strategy for communicating with your lender in order to minimize the impact of any potential covenant breaches. Please contact our team to learn more.