Understanding Covenant Violations

Members | March 13, 2012

Covenant violations are an early warning system for retirement communities to help keep their financing on track. This article from LeadingAge Partner Ziegler explains what covenant violations mean and what they don't. 

By most accounts, the vast majority of senior living providers are managing through the current economic doldrums remarkably well. Occupancy rates for continuing care retirement communities rose quarter-over-quarter and year-over-year in the last quarter of 2011, according to NIC MAP®1

Ratings downgrades in the sector averaged fewer than 11 downgrades per year from 2008-2011, below the 10-year average pace of about 13 downgrades per year from 2002-2011. 

The median Net Operating Margins (NOM) for both system and single-site providers are at their highest levels in the history of the CARF-CCAC Financial Ratios and Trend Analysis publication, for the reported 2010 fiscal year. 

Providers are proactively branching out into innovative products and services aimed at serving the next generation of consumers. And, each year, tens of thousands of seniors choose a continuing care retirement community for their new home. 

Yet, for all of the ways providers are exceeding expectations, a small number of high-profile monetary (payment) defaults and bankruptcy filings in the senior living industry has led to heightened scrutiny of CCRCs.

As they should. While each borrower that experienced a payment default and/or filed for bankruptcy protection had individual circumstances that led to the default or bankruptcy, it is important that professionals in the senior living industry are reflecting upon and learning from the experience of others (for example, the session "Management in Action: Responding to Community Challenges" at the upcoming 2012 National Senior Living CFO Workshop). 

Otherwise, while the number of monetary defaults in the industry has risen, they remain rare. Methodologies vary, but statistics range from just over 2%, according to Municipal Market Advisors as reported recently in The Wall Street Journal, to about 6% in our own 1990 - 2010 study (2% if recovered debt is included). 

Unfortunately, however, this increased attention has also led to misinformation, particularly in the area of covenant violations where the range of financial 'distress', from a covenant violation to a bankruptcy or monetary default is not well understood. 

Misunderstanding the distinction between the 2 concepts leads to industry pundits poorly wording their analogies and shows a lack of understanding. We hope this Z-News helps readers understand the differences as they walk through these issues with residents, depositors, boards and staff. 

How covenants are set

As the providers who have issued fixed-rate debt within the last ten years may remember, crafting the bond covenant package for any particular deal is among the more complicated tasks in the financing process.  

While there are certain standard covenants -- insurance requirements, requirements to pay taxes, keep books and records, etc. -- the more meaningful covenants are the operating or business covenants, which measure the operating and financial performance of the borrower. 

These operating covenants vary based primarily on 3 components:  

  1. The nature of the project and/or financing.
  2. The credit quality or perceived risk of the financing and organization.
  3. Investor sentiment and the financing environment at the time of issue. 

Covenant component 1: nature of the product

First, the nature of the project is the biggest driver of operating covenants because the operating stage of a borrower will define the measurable benchmarks of success. 

For example, a stable community will typically have covenants testing operations (debt service coverage ratio) and often liquidity (days' cash on hand) as measures of financial soundness.  

A stand-alone new campus, however, will not yet have the operations or unrestricted cash to measure, so covenants for these financings include testing marketing levels, occupancy levels and other items that indicate success or concern at that lifecycle stage.

Covenant component 2: credit quality

The second covenant driver is the credit quality or perceived risk of the project and the organization. In general, borrowers with rated debt have covenants that are less strict than borrowers with non-rated debt. For example, a typical stable, non-rated single-site community may have a days' cash on hand requirement of 180 days. 

In contrast, it is not unlikely for a rated, multi-site borrower to have a liquidity covenant of 120 days' cash on hand, or for senior living borrowers rated in the "A" category to have no liquidity covenant at all. 

A stand-alone new campus will have a much different covenant package than a new campus financed inside the obligated group of a larger system.

Covenant component 3: finance timing

Finally, a third driver of covenant packages is the timing of the financing. While covenant packages do follow the general patterns discussed above, every financing entails a subtle (and sometimes not so subtle) negotiation with investors over specific covenant terms. When credit is widely available, covenants tend to loosen; when credit is tight, covenants generally become tougher. 

In some cases, a borrower may elect for a tighter covenant package to bring more investors into the financing and capture a lower interest rate for their bonds. In addition, covenants change over time as new and better ways of measuring performance are developed and as the industry evolves. 

In summary, 2 senior living providers may be in the exact same financial position, with 1 violating a covenant and the other not, solely because their specific covenanted levels are different. 

Covenants as triggers for action

For investors monitoring dozens of individual borrowers in a portfolio, covenant violations serve as early warning signs that greater attention is needed. Covenant levels are typically set at minimums well above a level that would indicate financial distress or a looming monetary default. Rather, investors seek a high threshold so that a community may rectify their challenges before they become more severe. 

Covenant violations have increased over the past few years due primarily to marketing and occupancy covenant violations by borrowers that had new construction projects and were in the process of selling and occupying new independent living units when the housing market collapsed and the pace of move-ins slowed across the country. 

Anecdotally, upticks occurred in debt service coverage ratio violations due to lower net entrance fees from softer turnover and in liquidity covenant violations, mainly in 2009, due to the equity market drop. Violations of operating covenants typically require the borrower to engage a consultant to make recommendations to the governing board for how to achieve covenanted levels in the future.

Positioning for the Road Ahead

Recessions stress the resiliency of all economic sectors and the senior living sector is no exception. Today, the industry as a whole is operating under the assumptions of a changed world view. 

Providers who are undertaking new projects are building into their models additional conservatism and liquidity reserves to account for longer fill-up periods. Stable providers continue to focus on reducing reliance on turnover entrance fees to cover operating or debt service costs. 

Financially challenged providers are raising their hands for potential affiliation partners. As the demand for senior living options continues to grow with the demographics, proactive providers are positioning themselves to serve more seniors in a growing number of ways.

Prepared by Amy Castleberry, CFA, senior vice president
Mike Taylor, vice president

1 NIC MAP® Data and Analysis Service, NIC MAP Monitor® 4Q11