The cure for a failed loan-to-value test is a two-line sum, but the second line depends on how the agreement counts cash collateral.
If the agreement deducts cash deposited with the lender from the loan, the cure is the loan less the covenant times the new value. On an illustrative 52,000,000 loan whose security falls from 80,000,000 to 68,000,000, that is 4,400,000 against a 70 per cent covenant. If the agreement instead adds the deposit to the value, the same breach needs 6,285,714, 1.429 times as much. The definition clause, not the valuation, decides which.
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 →
Loan-to-value covenants are tested on a valuation the lender commissions, usually once a year or when it has reason to think values have moved. When a test fails, the borrower typically has a short period to cure, by prepaying part of the loan or by depositing cash in a blocked account charged to the lender. How much cash that takes is a two-line calculation, but the second line depends on wording that is easy to miss.
| Input | Value |
|---|---|
| Loan outstanding | 52,000,000 |
| Value at origination | 80,000,000 |
| LTV at origination | 65.0% |
| LTV covenant (maximum) | 70% |
| New valuation | 68,000,000 |
| Loan interest rate | 5.5% |
| Prepayment fee | 1% |
The covenant fails once value falls below the loan divided by the covenant: 52,000,000 ÷ 0.70 = 74,285,714. That is a fall of 7.14 per cent, a cushion of 5,714,286. The new valuation, 15 per cent down at 68,000,000, puts LTV at 76.47 per cent. Which test fails first when income and value fall together is compared in LTV, DSCR or debt yield: which breaches first.
Deposit netted from the loan, or prepayment: cure = L − c × V
Deposit added to the value: cure = L ÷ c − V
52,000,000 − 0.70 × 68,000,000 = 4,400,000. 52,000,000 ÷ 0.70 − 68,000,000 = 6,285,714. In Excel, with L in B1, c in B2 and V in B3: =B1-B2*B3 and =B1/B2-B3.
The ratio between them is exactly 1 ÷ c, 1.429 at a 70 per cent covenant. Netting a deposit from the loan reduces the numerator one for one; adding it to the value raises the denominator, which the covenant then only counts at 70 per cent. Most agreements written for investment loans net the deposit off the loan, but some define the security value as property plus cash collateral, and borrowers who sign that have accepted a 43 per cent more expensive cure without noticing.
A prepayment of 4,400,000 costs a 1 per cent fee, 44,000, and saves 242,000 a year of interest at 5.5 per cent, but the cash is gone for good. A deposit of the same size stays the borrower's money and is usually released once the covenant has been met for a set number of tests. Earning, say, 3.0 per cent on deposit against a loan costing 5.5, it costs 110,000 a year to carry. A borrower that expects values to recover deposits; one that does not prepays.
| Fall | Value | LTV | Prepay or netted deposit | Deposit added to value | Cure to 65% |
|---|---|---|---|---|---|
| 5% | 76,000,000 | 68.42% | 0 | 0 | no breach |
| 10% | 72,000,000 | 72.22% | 1,600,000 | 2,285,714 | 5,200,000 |
| 15% | 68,000,000 | 76.47% | 4,400,000 | 6,285,714 | 7,800,000 |
| 20% | 64,000,000 | 81.25% | 7,200,000 | 10,285,714 | 10,400,000 |
| 25% | 60,000,000 | 86.67% | 10,000,000 | 14,285,714 | 13,000,000 |
| 30% | 56,000,000 | 92.86% | 12,800,000 | 18,285,714 | 15,600,000 |
Past the breach point, every 1 of value lost needs 0.70 of prepayment, and every 1 needs a full 1 of deposit when the deposit is added to value. The last column is the cure some lenders ask for when the agreement requires LTV to return to its origination level, or when a cure is being negotiated after the cure period has lapsed. At the 15 per cent fall it is 7,800,000, 3,400,000 more than the covenant itself needs.
Cures are also not one-offs. If the next valuation is 5,000,000 lower again, at 63,000,000, the borrower that prepaid needs a further 3,500,000: 0.70 times the new fall. Agreements usually cap the number of cures over the life of the loan, so the first cure should be sized with the second in mind.
Figures are illustrative. Whether a cure is available at all, how many times, and whether a deposit must be applied in prepayment after a period, is set by the agreement and differs widely between lenders and markets.
The cure provisions of a real estate loan, and what each one costs, are priced in the free workbook for this book.
The cure by prepayment is the loan less the covenant level times the new value. On an illustrative 52,000,000 loan revalued at 68,000,000 against a 70 per cent covenant: 52,000,000 less 47,600,000 is 4,400,000. If the agreement counts a deposit as extra value, use loan divided by covenant less value: 6,285,714.
Prepayment saves interest but the cash is gone; a deposit is returned once the covenant has been met for long enough but costs the gap between the loan rate and the deposit rate. In the illustrative case a 4,400,000 prepayment saves 242,000 a year at 5.5 per cent; the deposit costs 110,000 a year to carry at 3.0 per cent.
Until value equals the loan divided by the covenant. A 52,000,000 loan against a 70 per cent covenant breaches below 74,285,714, a 7.14 per cent fall from an 80,000,000 valuation. Starting at 65.0 per cent LTV, the cushion is 5,714,286 of value.
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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