Loan Covenants And Technical Default

Default is commonly understood as missing a payment. Loan agreements define it more broadly, and a borrower who has never missed a payment can still breach the contract.

What covenants do

Covenants are ongoing promises about how the borrower and the property will behave. They give the lender information and early warning between the origination and the maturity.

Affirmative covenants require actions: deliver financial statements, maintain insurance, pay taxes, keep the property in repair. They are mostly administrative and mostly forgotten until missed.

Negative covenants prohibit actions: additional borrowing against the property, transfers of ownership interests, material alterations, or new leases outside agreed parameters without consent.

Financial covenants and the ratios they test

Debt service coverage covenants require income to exceed debt payments by a stated margin, tested periodically. A property whose income falls can breach without missing anything.

Loan-to-value covenants require the outstanding balance to stay below a share of appraised value, which can be breached by a valuation decline rather than any borrower action.

Liquidity and net worth covenants apply to the borrower or guarantor rather than the property, and they can be breached by events entirely unrelated to the building.

Why a technical default matters

Breaching a covenant typically gives the lender rights it did not previously have, which may include cash management control, additional reporting, or the right to accelerate the loan.

Cash sweeps are common. Rental income is directed into a controlled account and released only after debt service and reserves, which removes the owner's discretion over cash flow.

Acceleration, demanding the full balance immediately, is the most severe remedy and is generally not the first response, but its availability changes the balance of any conversation.

Cure periods and how they work

Agreements usually distinguish between defaults that can be cured and those that cannot, and specify a window during which the borrower can fix the problem.

Some covenants allow a cure through equity injection, where the borrower contributes cash treated as income or applied to principal so the ratio is restored.

The number of times such a cure can be used is normally limited, because unlimited cures would let a persistently underperforming property look compliant indefinitely.

Reading the agreement before signing it

Covenants determine how much room the borrower has if conditions change, which makes them at least as consequential as the interest rate for a long hold.

They are negotiable, particularly the testing frequency, the margin required and whether a breach triggers a sweep or an acceleration right.

Terms vary by lender and by jurisdiction, and enforcement practice changes over time, so reviewing specific documents with qualified counsel is the appropriate step before commitment.