A promise in a loan agreement that the borrower will do certain things, or will not, for as long as the loan is outstanding, such as keeping a minimum debt service coverage ratio.
Covenants let a lender keep watch after the money is out. Affirmative covenants are things the borrower must do, such as send financial statements and keep the property in repair. Negative covenants are limits, such as no added debt or liens without consent. Financial covenants are ratios tested on a schedule.
The OCC’s handbook lists the financial covenants it sees most on income property loans: debt yield, debt service coverage, loan to value, loan to cost, and a minimum net worth or liquidity for the borrower or guarantor. For construction loans it lists limits on speculative units, on unsold inventory, on additional debts, guarantees and liens, and on distributions to owners before repayment. SBA’s manual tells lenders making CAPLines to use balance sheet covenants such as a current ratio, tested quarterly, twice a year or yearly.
A missed covenant is a default under the agreement even when every payment was made on time. The agreement sets what the lender may then do, from waiving the breach to demanding repayment, so negotiate the levels and the testing formula before closing. A coverage covenant of 1.20 means little until you know which income and which payment go into it.
How it shows up in the data here
Not shown on this site. Covenants live in the loan agreement, and no call report, credit union filing, HMDA row or SBA record lists them. You can prepare for the common ones: test coverage with the DSCR calculator and loan to value with the LTV and LTC calculator, then ask each lender which ratios it tests after closing and how often.
Go further
- DSCR calculator: Coverage from income, expenses and loan terms you enter.
- LTV and LTC calculator: Loan to value and loan to cost from figures you enter.
- DSCR calculator: Cash flow over debt service. Type the cash flow and the loan terms, see the ratio and the cushion before it falls to 1.00x.
- Debt yield calculator: Cash flow over the loan. The one ratio that ignores the rate, the amortization and the cap rate.
- LTV and LTC calculator: Loan to value and loan to cost, the equity a lender will ask for, and the federal supervisory limit for the property type.
- How bankers evaluate a commercial loan deal: A credit officer asks one question five ways: how will this loan be repaid, and what happens if it is not? Knowing the five tests lets you size a request before you send it.
- What a lender-ready loan package looks like: A lender decides in minutes whether to keep reading. A package that answers the first five questions on one page, and backs each answer with a document, gets read.
Related terms
- Debt service coverage ratio (DSCR): Net operating income, or business cash flow, divided by the loan payments due in a year. It shows how many dollars come in for each dollar of debt service.
- Debt yield: Net operating income divided by the loan amount, shown as a percent. It measures how much income stands behind each dollar lent, whatever the rate or term.
- Loan-to-value ratio (LTV): The loan amount divided by the value of the property securing it. A $700,000 loan on a property valued at $1,000,000 is 70 percent loan to value.
- Post-closing liquidity: The cash and other liquid assets a borrower or guarantor still holds after paying the down payment and closing costs on a loan.
- Borrowing base: The most a lender will advance on a line of credit at a given time, set as a percentage of the eligible receivables, inventory or other collateral pledged.
- Term sheet: A term sheet is a short written outline of the loan a lender is prepared to consider: amount, rate, term, fees and main conditions. It is usually not binding.
Sources
Plain definitions for orientation, not legal, tax or credit advice. A lender's own policy decides what it will do.