Three covenants, three headrooms, and only one of them matters on the day income turns. The ranking is arithmetic, and it changes with the asset and the debt.
Solve each covenant for the fall in net operating income that breaks it, then rank the three. On an illustrative €65.0M interest-only loan against a €100.0M property yielding 6.00 per cent, at 5.50 per cent interest, the loan-to-value test breaches on a 7.1 per cent fall in income, the debt yield on 13.3 per cent and the DSCR on 22.5 per cent. LTV breaches first, and the DSCR, with three times the cushion, is the last test to worry about.
Worked in full in Real Estate Finance by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
This is the in-life question, not the sizing one. At origination a lender sizes the loan to whichever test gives the least debt, as in how a refinancing gap is closed. Once the loan is drawn the balance is fixed, and the question for the asset manager and the lender's monitoring team changes: how far can income, value or the rate move before each covenant trips, and which trips first?
A stabilised property is valued at its income capitalised at a 6.00 per cent yield. The loan is interest only, so debt service is the loan times the rate. The facility agreement tests three covenants. All figures are illustrative.
| Input | Value | Covenant |
|---|---|---|
| Net operating income | €6.0M | |
| Valuation yield | 6.00% | |
| Market value | €100.0M | |
| Loan, interest only | €65.0M | |
| Interest rate, all-in | 5.50% | |
| Debt service | €3.575M | |
| Loan-to-value | 65.0% | max 70% |
| Debt service cover | 1.68x | min 1.30x |
| Debt yield | 9.23% | min 8.0% |
Put the three tests on one scale: the percentage fall in income that takes each to its limit. For the LTV, assume the valuer holds the yield, so value falls one for one with income.
LTV headroom = 1 − current LTV / maximum LTV = 1 − 65.0% / 70% = 7.1%
Debt yield headroom = 1 − minimum / current = 1 − 8.0% / 9.23% = 13.3%
DSCR headroom = 1 − minimum / current = 1 − 1.30 / 1.68 = 22.5%
Excel: =1-LTV/MaxLTV, =1-MinDY/DY, =1-MinDSCR/DSCR, then =MIN(...) names the binding test.
In money: LTV breaches when value falls to €92.86M, which at a constant yield is income of €5.57M. Debt yield breaches at €5.20M of income. DSCR breaches at €4.65M. The credit paper should carry one line: binding test, loan-to-value, breaching on a 7.1 per cent fall in income; debt yield second at 13.3 per cent; debt service cover not a constraint.
The ranking is set by two spreads. LTV against debt yield is a question of the valuation yield: the debt yield is income over loan, and LTV is loan over income divided by the yield, so on a 6.00 per cent asset a 70 per cent LTV limit is equivalent to a debt yield of 8.57 per cent, tighter than the 8.0 per cent covenant. DSCR against the other two is a question of the interest rate: with debt at 5.50 per cent against a 6.00 per cent yield, income covers interest comfortably long after the value has moved.
LTV also moves on its own. Hold income flat and widen the valuation yield: the test breaches at 6.46 per cent, 46 basis points out. A 25 basis point widening alone takes value to €96.0M, a 4.0 per cent fall, and LTV to 67.7 per cent. Combine a 5 per cent income fall with the same widening and value is €91.2M, LTV 71.3 per cent, and the borrower needs a €1.16M paydown to cure.
The DSCR has its own trigger that the income test does not show: the interest rate. On a floating loan, cover falls to 1.42x at plus 100 basis points and to 1.23x at plus 200, a breach with income unchanged. The rate at which DSCR breaches is 7.10 per cent, 160 basis points of headroom.
The same engine on three loans shows the ranking flip. Each property is worth €100.0M; the covenants are unchanged.
| Loan | Yield | Rate | LTV | DSCR | Debt yield | LTV headroom | DSCR headroom | DY headroom | Binds first |
|---|---|---|---|---|---|---|---|---|---|
| A, the base case | 6.00% | 5.50% | 65.0% | 1.68x | 9.23% | 7.1% | 22.5% | 13.3% | LTV |
| B, high yield, dear debt | 8.00% | 9.00% | 60.0% | 1.48x | 13.33% | 14.3% | 12.2% | 40.0% | DSCR |
| C, low yield, low leverage | 4.50% | 5.00% | 55.0% | 1.64x | 8.18% | 21.4% | 20.6% | 2.2% | Debt yield |
Loan B sits on a higher-yielding asset with debt costing more than the yield: negative leverage, and the cover test binds first. Loan C looks conservative at 55.0 per cent LTV, but on a 4.50 per cent asset the 8.0 per cent debt yield floor is almost touching: a 2.2 per cent fall in income breaches it. The lowest LTV on the page has the least headroom.
The mistake is to compare the gaps in each ratio's own units. Five points of LTV, 0.38x of cover and 1.23 points of debt yield cannot be ranked against each other until each is converted into the same unit, the fall in income that closes it. Converted, the LTV cushion on loan A is 7.1 per cent of income against 22.5 per cent for the DSCR, and on loan C the debt yield gap of less than a fifth of a point, 8.18 against 8.0, is the cushion that matters, smaller than either of the others by a factor of more than nine. The second mistake is to forget that the LTV can be breached by a valuer with no tenant leaving at all. For the paydown arithmetic once a test has failed, see how long a cash sweep takes to cure a debt yield trigger, and for sizing a new loan on all three tests at once, the DSCR, debt yield and LTV template.
The three tests, the shocks and the three-loan comparison are live in the free workbooks for the book's case, so the ranking can be watched as the yield and the rate move.
Express each test as the fall in net operating income that takes it to its limit. For a maximum LTV it is one minus current LTV over the covenant, if value moves with income at a constant yield. For a minimum DSCR or debt yield it is one minus the covenant over the current ratio. At 65 per cent against 70, the LTV headroom is 7.1 per cent.
Because value capitalises income at the yield while debt service costs the interest rate. When the property yields 6.00 per cent and the loan costs 5.50 per cent, a 1.68x DSCR leaves a 22.5 per cent cushion but a 65 per cent LTV leaves only 7.1. A yield shift of 46 basis points breaches LTV with no change in income at all.
Yes, on a floating rate. The illustrative loan covers 1.68x at 5.50 per cent; at 7.50 per cent, 200 basis points higher, cover is 1.23x and below a 1.30x covenant, with income unchanged. The rate that breaches is 7.10 per cent, 160 basis points of headroom, which is why floating-rate loans carry hedging requirements.
Sizing, and the test that binds, is the subject of Chapter 4 of Real Estate Finance. 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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