As busy as the self storage industry has been over the last five to seven years, not much has been written or discussed recently about the language of loan covenants for buying or building self storage facilities. Yet, as the market has started to tighten, occupancies have started to level off and cash flow has begun to steady, it is the first time in a long while where some banks are starting to reach out to their customers asking for more current financial reports and have started to analyze the financial condition of the properties for which they have provided loans.
So, what is in that loan agreement that you’re signing? Simply stated, when you borrow money from a financial institution, you are agreeing to specific terms and conditions that must be met for that loan to stay out of default. Certainly, the number one requirement is that the loan be repaid in accordance with its installment schedule. That’s the easy one. You miss a mortgage payment and you risk going into default. The more unusual and uncommon occurrences are when the bank reviews your financials and claims that you are not meeting the financial benchmarks that have been created as part of your loan covenants. If that happens, the loan could be pushed into default unless you take certain action to cure that default.
Again, since the industry has been on a valuation high for almost a decade, the recognition of what requirements are in your loan covenants has often been overlooked or ignored. It is important to once again consider the deal you’re signing off on.
A loan covenant is simply defined as a set of conditions in a loan that requires the borrower to fulfill or, on the other side, which forbids the borrower from undertaking. And, as discussed, the violation of any of those covenants may result in the loan being declared in default, penalties being applied, or even the loan being called. If the loan is called, all future payments due under the loan can be "accelerated", which means that the full amount of the loan is immediately “due and payable”.
The typical covenants found in a lending deal include 1) Affirmative Covenants which include both operation requirements (like paying the mortgage, paying taxes and avoiding liens on the property) and reporting requirements (like delivering regular financial statements); 2) Negative Covenants, such as preventing the right of the borrower to merge or sell its business, sell any of its assets or make payments to its owners or shareholders, without lender approval and; 3) Financial Covenants which establish specific balance sheet requirements, liquidity amounts or debt ratios that must be maintained in order to keep the loan in place. These ratios would typically be based on how the business originally calculated their future performance and revenue.
Again, if one of loan covenants is violated, the lender might notify the borrower and require the borrower to balance the ratios by paying the bank back on a certain portion of its loan, often called a “cash-call”. Since this is not a situation that most borrowers anticipate, if a cash call is made, this may be the tipping point for what might end up as a loan default. If such a situation occurs, the recommendation is always to seek a resolution with your bank to try to solve the problem rather then to hide from it. A borrower’s failure to honestly communicate with its lender can often lead to greater suspicions from the lender. Certainly, one lesson learned from the financial crisis of the late 2000’s is for the parties to seek solutions to restructure troubled debt rather than to pull the plug on the loan itself. Ultimately, if a plan of correction is attempted, make sure it is based on an honest assessment of the current financials of the business to avoid the risk of another default. If that happens, it may otherwise be too late to fix the problem again.