UK: Bank Consents – Risks And Reasons

Last Updated: 26 October 2010
Article by Douglas Gourlay

The good old days (and the less good new days)

Banks have always imposed controls on borrower activities, including letting or taking property on let, through facility and security covenants.

But it's perhaps fair to say that in the past there was little investigation by those banks of the precise lease terms, provided they were satisfied with tenant covenant and proposed rental. There were exceptions in the case of key or high value purchases or lettings – but generally there wasn't a great deal of oversight.

It's now easy to see that perhaps that wasn't a sustainable position from a risk management perspective.

Today the property industry operates in a different environment – one which is much more risk-averse. That means lenders are taking a far greater interest in the detail of existing occupational leases when funding a purchase and any dealing in secured property.

The bank's concerns

Most commonly we're talking about an existing property which is let to one or more tenants, providing a revenue stream to the landlord and contributing to an enhancement of value of the asset as compared to its unoccupied state.

The income which is generated through payment of rent under the occupational leases will comprise a substantial part of the value of the investment – so, in providing funding, the bank is clearly interested in ensuring that sufficient value is retained in the property in order to meet the borrowing in the event of default.

That means it's in the interests of the bank to look carefully at the terms of the occupational leases to ascertain their quality – and that's a view which is taken from the landlord's point of view against the possible calling-up by the bank of the security and the sale of the security subjects, either immediately or perhaps after some time, with the bank running the investment property in the interim.

So what is the bank really interested in?

1. The bank's main concerns surrounding any occupational lease will obviously centre on the basic commercial terms and how those relate to asset value and interest service – but the bank are also looking at the more intangible aspects of marketability and the extent of tenant covenants and landlord liabilities.

The continuation of revenue stream and determination of the value of the property will depend largely upon the duration of the lease, the amount of rent and the frequency and provisions for rent review.

Clearly the state of the economy has had an adverse effect on the cash flows of all kinds of businesses and for those operating from leased premises, quarterly rental payments are likely to be one of the biggest outgoings.

The longer the rental payment remains in the tenant's bank account, the more interest they will accrue and the more likely that cashflow issues will be eased. Of course late payment isn't ideal from the landlord's point of view and could prove to be an early warning sign of real financial difficulty and that the tenant is unable to pay its debts as they fall due.

That's another reminder that in the investment context, evaluation of tenant covenant is a vital part of the process for both borrower and bank – there's little point in bringing a tenant on board if there's every likelihood of default in the foreseeable future.

2. However, the detailed terms of the lease beyond tenant covenant and headline provisions also potentially impact on both cash flow and business value, as well as more broadly on the landlord's ability to service its loan commitments.

Other issues the bank will likely want to consider will include service charge recoverability, the existence of turnover rents, and deviation from full repairing and insuring terms.

Each of those will have an effect on value – and, in extreme cases, could impact on marketability of the asset.

So, ideally, an occupational lease should maximise the return to the landlord while minimising risk – and this holds true from the perspective of either landlord or its funder.

For example, in the case of a single occupancy, there would ideally be a substantial tenant covenant, an FRI format with no residual liability attaching to the landlord, a market value rent, no tenant breaks and regular upwards-only rent reviews.

There's nothing surprising in this, and it's simply the case that the bank is looking for what the landlord itself should expect – the only difference being that the bank is less likely to accept concessions or deficiencies.

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