The two standard measures for lending secured on commercial real estate are interest cover (does the rental income cover interest costs and then some?) and LTV – loan to value (is the amount of the outstanding principal less than a certain percentage of the property’s value?). In the wake of the financial crisis, such lending has fallen dramatically and, perhaps more keenly than before, lenders are keeping a close watch on whether these financial tests are being met.
In previous years, an LTV breach may have been ignored particularly if the borrower could demonstrate that income was sufficient to service the interest payments on the loan. However, in the current market, with new capital requirements and liquidity standards, a breach is far more likely to result in a default being declared and early repayment demanded.
Read the agreement
The LTV test has to be specified in the loan agreement – there is no ‘deemed’ test.
Common wording is usually to the effect that the borrower must ensure that, at any given time, the amount of the outstanding loan at that time does not exceed a specified percentage (usually 70% or less) of the property’s value at that time.
Value for these purposes is often taken to be the market value as shown by the most recent valuation of the property (usually undertaken by a named valuer/surveyor or one approved by the lender), with market value being determined on the basis of the RICS Statements of Asset Valuation Practice (commonly referred to as the Red Book).
So, on its face, an easy and comprehensible mechanism – you get the valuation, check the account for the outstanding loan, do the maths and the test is either met or it’s not. If it is not, the lender may wish to say a default has occurred and exercise its rights; but has the test in fact not been met?
…and read it in detail
A valuation and the state of the loan account may on their face show a breach of the LTV test, but has there been compliance with the loan agreement’s requirements? For example:
- has a formal valuation actually been produced or just a schedule of values?
- is the valuer the one specified in the loan agreement?
- does the valuation actually comply with Red Book requirements?
- the ‘most recent’ valuation may be some months old; with the recent recovery in some property values and looking at comparable properties, a borrower might plausibly argue that the default is not “continuing” (which is usually a requirement for a lender to be able to require early repayment and enforce its security).
As so often, the devil can be in the detail.
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