Breaching a loan covenant can feel like an impending catastrophe. Declining market conditions, significant unexpected expenses, and/or loss of a major tenant can all lead to a potential default.
However, the steps you take after forecasting a covenant breach may significantly impact your ability to successfully navigate the situation.
This guide outlines a clear, practical roadmap for property owners who are forecasting a loan covenant breach, focusing on analysis, strategic planning, and proactive communication.
Step 1: Acknowledge and Understand the Problem
Before communicating with your lender, you should have a solid understanding of the underlying causes of the impending breach. Is the property experiencing a short-term cash issue or deeper, fundamental challenges? Conducting a thorough analysis to identify and quantify all contributing factors (e.g., higher interest rates, insurance loss, challenges in finding replacement tenants, etc.) is essential.
This analysis lays the groundwork for communicating with your lender, demonstrating that you’re both aware of the issues and actively considering ways to mitigate them.
As part of your analysis, you should pinpoint potential covenant issues implied in your go forward projections.
Review your loan documents to understand the specific covenants you’re breaching, the consequences outlined in your agreements, and any lender rights or remedies. This step is critical to determining the scope of your exposure, including potential impacts on guarantees, cross-default clauses, and other credit agreement provisions. You should consult your internal or external counsel to validate your interpretation of the loan documents.
Step 2: Communicate with Your Lender
Avoid the temptation to delay or obfuscate your financial challenges. Proactive engagement is crucial during this process. Your lender will appreciate the transparency and as a result, may be more willing to work with you if they’re informed before a default.
Your communication plan should include:
- A clear and succinct explanation of the problem (for example, “unexpected capital expenditures”).
- Evidence of the steps you are already taking to mitigate the situation.
- Financial projections illustrating the covenant breach and when it will occur
A detailed, forward-looking plan signals both proactivity and a commitment to collaboration, fostering trust and goodwill with your lending partners.
Step 3: Develop a Remediation Plan
Lenders want to see actionable solutions. Here, you might benefit from the insight of a financial consultant or a real estate restructuring expert to craft a remediation plan.
Your remediation plan begins with your financial projections, which should incorporate the steps you are planning to take over the coming months (or years) to improve the property’s performance, and illustrate covenant compliance (or non-compliance).
Your remediation plan has to be realistic. Overpromising and underdelivering will only serve to erode trust between you and your lender.
Step 4: Assess Your Options
You may need to consider alternative strategies if your lender isn’t receptive or if your financial outlook continues to worsen. You should also engage your legal counsel to fully explore your options such as:
- Loan modification: Negotiate revised terms, such as covenant waivers or temporary payment deferrals.
- Voluntary sale: Evaluate whether selling the property can salvage value and prevent foreclosure.
- Debt restructuring: Work with your lender to reconfigure your debt to better align with cash flow.
- Refinancing: Work with a mortgage broker or investment banker to obtain financing from a lender who is easier to work with or may provide more favorable terms that better align with cash flow
- Bankruptcy protection: While a last resort, this may provide time to reorganize and protect your assets.
- New investor: Negotiate an equity investment with an individual, family office or institutional investor to recapitalize the property.
Step 5: Keep Calm and Act Decisively
Facing a covenant breach isn’t ideal, but there’s no reason to panic. Many lenders prefer to work with property owners in order to find mutually beneficial solutions, particularly those who may be a source of additional future business.
With transparent, and proactive communication, you can improve your chances of resolving the issue and protecting your investment. Preparation and communication are your strongest assets when managing financial difficulties.