Amidst market turmoil following the political circus that has consumed the UK over recent months, Laura Oliver and Dan Keys consider the impact on banking covenants and advise borrowers and lenders to keep talking.
Even before the disastrous mini budget and the jaw dropping fallout which produced the shortest serving British Prime Minister, the financial markets were predicting a fall in commercial property values by as much as 15% as rising interest rates make financing deals more expensive. On the ground, all of us in the commercial property industry have started to see those deals being pulled, but even deals without finance are becoming sticky as investors become more cautious about how much they are willing to pay whilst those who need to refinance existing deals are facing uncomfortable and uncertain increases in interest rates.
The causes of the looming financial crisis are myriad. The war in the Ukraine coupled with rising energy prices, post-COVID and post-Brexit shocks and the strong dollar had already created an uncomfortable background inflationary environment to which has been added political uncertainty and U‑turns on fiscal policy that have inevitably spooked the financial markets. Whilst Rishi Sunak’s first days as Prime Minister appear have seen market stability improve and interest rates on Government debt fall, there remains a £40 billion black hole in the country’s finances.
Those who bet on a more bullish market when times were good should now be dusting off their loan agreements and reminding themselves what their banking covenants say — because breaching them is an event of default which will entitle lenders to demand immediate repayment. It may also trigger cross default in relation to other loans.
Banking covenants are contractual obligations owed by a borrower to its lenders and are designed to ensure that the borrower operates within agreed limits. Their purpose is twofold: first to ensure that the borrower can repay its debt and secondly to operate as an early warning system where the borrower is showing signs of distress. They are often heavily negotiated because the borrower will have a wary eye on whether they could restrict the day to day running of its business.
Banking covenants fall into three broad categories:
- Information covenants: These are intended to ensure that information about a borrower’s business is provided to the lender on a regular basis. As well as the provision of accounts and information that is commonly provided to shareholders, they cover information that will allow the lender to test the financial covenants – for example the provision of property valuations.
- Non-financial covenants: These are intended to preserve the quality of the existing assets and the standing of the lender in relation to third parties – for example to keep the property in good repair and condition. They also seek to control disposals – for example the terms of any lettings. Of key importance is the “negative pledge” which restricts the borrower’s ability to grant further security.
- Financial covenants: These are intended to preserve the quality of the loan and the borrower’s ability to service the debt. The key concern in a market where property values are falling and construction costs are rising is the covenant to maintain the loan to value ratio and, if applicable, loan to costs ratio.
The last time that there were widespread breaches of banking covenants was the credit crunch in the late 2000s and generally lenders took a fairly pragmatic approach where interest payments were being met. To a large extent this was a result of Government intervention in the lending market, which at the time felt like an extraordinarily bold move. The concern this time around is that Government policies have fuelled the very conditions which have made the market unstable.
The hope now is that, by junking the central planks of the mini budget and switching Prime Ministers (again), the Government can instil some stability in the financial markets that will feed through to lower yields on the bond market and stability in respect of the interest rates offered by lenders. If that happens it should unlock deals and allow existing borrowers to refinance. Because of the global inflationary background interest rates will inevitably remain much higher than they were six months ago, but with some stability and certainty the real estate market should become more settled.
From a practical perspective, borrowers should approach their lenders well ahead of any likely breach and maintain an open dialogue. It may be possible to renegotiate the terms of loans, but in a weak lending market that will almost certainly come at the price of higher interest payments and fees.
In the meantime, lenders should assess the loans on their books to establish where breaches are likely to occur. They should also consider restructuring loans where borrowers otherwise have good business plans and a strong relationship with the lender.