The cash management clauses decide who is paid first every month; run numbers through them and the borrower's margin turns out much thinner than the covenant suggests.
All rent goes into a lender-controlled account and is paid out in a fixed order: tax and insurance reserves, debt service, budgeted operating costs, capex and leasing reserves, and only then the borrower. On an illustrative 6,000,000 of rent the borrower is left with 450,000, 7.5 per cent of the rent, so every 1 per cent of rent lost removes 13.3 per cent of its cash. A 6.75 per cent fall trips the cash trap at 1.15x DSCR; a 7.5 per cent fall leaves nothing to trap.
Worked in full in How to Read a Real Estate Loan Agreement by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The cash management provisions are the part of a real estate loan agreement that decides who is paid first, every month, without anyone having to call a default. Reading them as a waterfall, and running numbers through it, shows how thin the borrower's position is and how little room the lender's triggers leave.
| Input | Per year |
|---|---|
| Gross rent collected into the lockbox | 6,000,000 |
| Real estate taxes and insurance | 600,000 |
| Debt service on a 55,000,000 loan | 3,300,000 |
| Operating expenses, approved budget | 1,200,000 |
| Capex reserve | 150,000 |
| Tenant improvement and leasing commission (TI/LC) reserve | 300,000 |
| Cash trap trigger | DSCR below 1.15x |
Tenants are directed to pay into a lockbox account controlled by the lender. A common order of payments in the cash management agreement, which this example follows, is:
| Priority | Amount | Cash left |
|---|---|---|
| Rent collected | 6,000,000 | |
| 1. Taxes and insurance reserve | 600,000 | 5,400,000 |
| 2. Debt service | 3,300,000 | 2,100,000 |
| 3. Operating expenses (approved budget) | 1,200,000 | 900,000 |
| 4. Capex reserve | 150,000 | 750,000 |
| 5. TI/LC reserve | 300,000 | 450,000 |
| 6. Excess cash to the borrower (or trapped) | 450,000 |
The borrower receives 450,000, which is 7.5 per cent of the rent and 10.7 per cent of the 4,200,000 of NOI. Everything above it is paid to someone else, or held by the lender, before the borrower sees a penny.
The covenant DSCR is NOI over debt service: 4,200,000 ÷ 3,300,000 = 1.27x. The trap fires when it falls below 1.15x, so at an NOI of 3,795,000. Because taxes, insurance and operating costs do not fall with rent, that is a rent of 5,595,000, a fall of only 6.75 per cent.
Rent at trigger = trigger × debt service + taxes and insurance + operating expenses
1.15 × 3,300,000 + 600,000 + 1,200,000 = 5,595,000. In Excel: =B7*B3+B2+B4. How the covenant's own definitions of income and debt service change this ratio is worked in how to calculate DSCR under a loan agreement.
| Rent fall | Rent | NOI | DSCR | To borrower | Trapped | Reserves unfunded |
|---|---|---|---|---|---|---|
| 0% | 6,000,000 | 4,200,000 | 1.273x | 450,000 | 0 | 0 |
| 3% | 5,820,000 | 4,020,000 | 1.218x | 270,000 | 0 | 0 |
| 5% | 5,700,000 | 3,900,000 | 1.182x | 150,000 | 0 | 0 |
| 7% | 5,580,000 | 3,780,000 | 1.145x | 0 | 30,000 | 0 |
| 7.5% | 5,550,000 | 3,750,000 | 1.136x | 0 | 0 | 0 |
| 10% | 5,400,000 | 3,600,000 | 1.091x | 0 | 0 | 150,000 |
| 15% | 5,100,000 | 3,300,000 | 1.000x | 0 | 0 | 450,000 |
Three things stand out. First, the borrower's cash is geared 13.3 to 1 against rent: each 60,000 of rent lost, 1 per cent, comes straight out of the 450,000. Second, the trap fires late in this structure: between a 6.75 and a 7.5 per cent fall it catches at most 45,000 a year, because the reserves above it absorb the cash first. Its value to the lender is less the cash it catches than the signal and the control: once tripped it typically stays on until DSCR has recovered for two consecutive quarters, so the cash of the recovery is held too. Third, beyond a 7.5 per cent fall the reserves stop being funded. At 10 per cent, 150,000 of leasing reserve is missing in the year the building most needs it; at 15 per cent DSCR is 1.000x and nothing beyond debt service and costs is paid.
Where a lender wants cash rather than a signal, the agreement adds a sweep that applies trapped cash to principal. How long that takes to restore a ratio is worked in how long a cash sweep takes to cure a debt yield trigger.
The order of payments, reserve sizing, trigger levels and release conditions differ between agreements and lenders. The figures here are illustrative.
The cash trap and sweep provisions are laid out clause by clause, with what each one costs, in the free workbook for this book.
An account controlled by the lender into which tenants pay rent directly. The lender then applies the cash in the order the cash management agreement sets. In the illustrative case 6,000,000 of rent pays 600,000 of tax and insurance reserves, 3,300,000 of debt service, 1,200,000 of costs and 450,000 of reserves before 450,000 reaches the borrower.
When a test in the agreement, usually DSCR or debt yield, falls below its trigger. With a 1.15x DSCR trigger, 3,300,000 of debt service and 1,800,000 of fixed costs, the trap fires once rent falls below 5,595,000, a fall of 6.75 per cent from 6,000,000, even though NOI has a 9.6 per cent cushion and DSCR sits 10.7 per cent above the trigger.
A trap holds excess cash in a lender-controlled account as additional security, usually released once the ratio recovers. A sweep applies it to repay principal, permanently. In the illustrative case the trap holds at most 45,000 a year before the excess is exhausted; a sweep would turn the same cash into lower debt.
This article is one calculation from How to Read a Real Estate Loan Agreement. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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