Part 3 – Get Better Loan Terms: Financial Covenants

What is the most important (and rarely discussed) part of your commercial banking relationship?  

Be your bank’s favorite customer.

PART 3: Financial Covenants

I. THE SETUP

The Closing:

• You spent months looking for the right property to buy.

• You finally get one under contract!

• Your find out your commercial loan request is approved by the bank!

• The appraisal and environmental reports come in – all good!

• Your bank sends you the loan documents.

• You want to be careful, so you hire an attorney to review. You get the green light!

• You close on the property!

Time to call all your friends and tell them you have the best banker in the world!

(At least this is what we hope you do)

12-24 months have passed…

Then… your banker calls you to set up a meeting.

II. THE PROBLEM

Operations:

• Your value-add plan is going well.

• You hit your projected rents.

• But expenses are higher than expected.

• Taxes and insurance went up significantly.

• You aren't quite hitting your NOI projections, but you can make your monthly payments with a little bit of room.

  
  

Your Covenant:

• Per the loan documents, you have a financial covenant that requires you to exceed a 1.25x DSCR every year.

• Put another way, the cash flow (before making your loan payment) needs to be 125% of your principal and interest payment.

• For example: Your annual P&I payment is $100,000, your cash flow before making payment needs to be $125,000.

  
  
  
  

Actual:

• You cash flow is only 110% of the loan payment. You have a 1.10x DSCR.

• You're required to have a 1.25x DSCR.

• You're in default of your loan documents.

• This puts your bank in a bad spot.

• The risk of your loan just went up, and they are now required to hold more in reserves for your loan.

• This makes your loan a lot less profitable.

• The bank now must decide on the next steps:

  • require a loan paydown to get you back into compliance with your DSCR covenant

  • start charging you fees/increasing your interest rate to let you know they are serious about getting back into compliance

  • ask you to sell the property

  • refinance your loan to get it off their books

  • foreclosure

  • give you a grace period to become compliant

III. THE SOLUTION

Before you are in default:

• Build cushion into your pro-forma. If the bank requires a 1.25x DSCR by the end of Year 2, request a loan amount that results in a Year 2 DSCR of 1.40x. Now you have 0.15x cushion in the event everything doesn’t go exactly as planned.

• On a monthly basis, track your cash flow and calculate your DSCR.  What you don't track, you can’t manage. By tracking your DSCR, you’ll have time to make adjustments at the property to hit the required DSCR.

After you are in default:

• Put together a plan that will result in your DSCR going from 1.10x to 1.25x over the next 12 months.

Example:

• reduce payroll,

• shop for less expensive insurance plans that still meet the lender's requirements,

• do more grassroots marketing to drive traffic to your property

• check-in with your property management company weekly instead of monthly

• Update your loan officer monthly on how things are going with this plan.

• Use excess cash to pay down the loan.

Successfully getting back into compliance with your DSCR covenant will go a long way in solidifying the relationship you have with your bank.  Banker – “When things get tough, this borrower gets it done.”

▶️ Upcoming

This is Part 3 of the series: "Be your bank's favorite customer."

This will help you:

1. Get you better loan terms

2. Exceptions that other customers at the bank don't get.